Fed Watch: Finally, ‘Walkin’ The Walk’

Key Takeaways

• The Fed raised rates 25 basis points to 3.75%–4.00%, validating bond-market expectations as persistent inflation pushed Chair Warsh to finally ‘walk the walk’ on his hawkish rhetoric.

• With core PCE inflation expected to remain near 3% and markets pricing another increase by year-end, September’s hike may not be the Fed’s last if growth stays firm and inflation remains sticky.

• Rather than signaling a new tightening cycle, the latest hike may represent a recalibration of last year’s rate cuts, with elevated Treasury yields keeping pressure on the Fed to stay the course.

The Federal Open Market Committee (FOMC) decided to raise rates by a quarter-point, bringing the new fed funds trading range to 3.75%–4.00%. The money and bond markets had been pricing in a potential rate hike at this gathering, and Warsh & Co. ultimately determined that such a move was warranted. That said, the ‘rate hike’ story does not end here. In fact, you can make the case that this is not over and that the bond market will continue to challenge the Fed to stay the course, data permitting.

Interestingly, Chairman Warsh had been ‘talkin’ the talk’ and giving the impression that he was an inflation hawk, but it wasn’t until this Fed gathering that he finally was ‘walkin’ the walk.’ Getting to this point, however, was not a smooth process. In fact, the Chairman put himself in this position through his prior rhetoric and, perhaps most importantly, his refusal to provide any forward guidance.

Based on Warsh’s Jackson Hole comments only a few weeks ago, the hawkish tenor he set forth provided him with no wiggle room. As you may recall, the Fed Chair emphasized that the Fed will ‘have work to do’ if inflation is not moving to its 2% goal ‘with speed’ and stated that the prior inflation data did not suggest that the trend had ‘meaningfully improved.’ Based on the most recent CPI report, it appears that there has been no moderation in price pressures.

OK, CPI is not the Fed’s preferred inflation gauge; the PCE Price Index is. We won’t get the most up-to-date reading for this measure until the end of this month, but based on inputs from the PPI/CPI reports, it looks as if year-over-year core PCE will still be at least 3%, or a full percentage point above the Fed’s target, which Warsh reiterated ‘is a firm, fixed target.’

Without this moderation, the bond market did the work and put Warsh in the corner. Based on yield levels across the maturity spectrum, as well as fed funds futures, the money and bond markets were telling Warsh & Co. to follow through. To provide perspective, the U.S. Treasury (UST) 2-year note yield rose to 100 basis points above the prior fed funds target, while the implied probability from fed funds futures priced in over 90% chance of a rate hike at the September FOMC meeting and an additional increase by year-end. In other words, two total rate hikes in Q4.

Let’s not forget the longer-dated sector of the curve. To be sure, the UST 10-year yield crossed the widely debated 5% threshold as well. We have highlighted the driving forces behind this move in prior blogs, and, make no mistake, one rate hike may not necessarily be the final arbiter of where longer-dated Treasury yields wind up.

The Bottom Line

There’s an age-old motto: When you see a chance, take it. The Fed took it, and now the question becomes: What next? If upcoming data continues to show solid growth and above-target, sticky inflation, we don’t necessarily see this rate hike as the beginning of a new tightening cycle, but rather as a removal of some of the rate cuts that occurred during the September–December period of last year.