Fed Watch: Is It A Matter Of When, Not If?

Key Takeaways

• Markets are now pricing a September rate hike and a total of at least two increases by next spring, suggesting investors should prepare for a Fed that has shifted from easing toward a more hawkish, data-dependent stance.

• Chairman Warsh's focus on price stability and "no tolerance" for inflation suggests resilient labor markets and incoming inflation data will determine whether the Fed begins reversing last year's rate cuts.

• Rather than the start of a new tightening cycle, the more likely outcome is a measured reversal of some of last year's rate cuts, making the Jackson Hole conference an important event for fixed income investors watching for policy clues.

Once again, the Federal Open Market Committee (FOMC) decided to remain ‘on hold’, keeping the fed funds trading range at 3.50%–3.75%. Although there had been earlier conjecture in the money and bond markets the Fed may raise rates at the July gathering, that sentiment ultimately faded, and the final result was largely expected.

For the record, this meeting marked Chairman Warsh’s second official policy convocation, and as we noted in our “A New ‘Warsh’ Cycle” blog and podcast, the bond market's attention is now shifting to what the Fed will actually do with the fed funds rate in the months ahead. At this point, investor sentiment seems to be focused on the notion of it being a matter of when, not if, in terms of a rate hike.

So, how did market sentiment get to this point you may ask? From a macro perspective, the labor market, and by extension the broader economy, appears to be in relatively good shape, a point the Fed Chair noted in his recent Semiannual Monetary Policy testimony. In terms of inflation, the cooler than expected June CPI report was viewed as more of a reason for the FOMC to not raise rates as soon as the July meeting, rather than eliminating the possibility of a rate hike later this year. In fact, Warsh has emphasized a number of times in public that the FOMC has "no tolerance" for inflation and has emphasized its commitment to "price stability." In addition, the Chair seemed to downplay the aforementioned CPI report.

If there is one carryover from Chairman Powell to Mr. Warsh, it’s that policymaking decisions remain highly data dependent. That being said, the money and bond markets have now not only closed the curtain on rate cuts but fed funds futures are pointing toward a rate hike at the September FOMC meeting, as of this writing. But it doesn’t stop there, as the market is pricing in at least two increases by next spring.

If it is a matter of when, not if, in terms of a rate hike, the natural question would be: what might that process look like? I do not believe a return to rate hikes would usher in a new tightening cycle. The more likely scenario would probably entail the Fed reversing one or more of the rate cuts, that were implemented during the September-December period last year. Actually, it’s rather interesting that as recently as December the FOMC cut rates, and now we’re writing about the possibility of multiple rate hikes as the Fed’s next move.

The Bottom Line

Our base case scenario continues to see a somewhat patient approach to the decision-making process, with the Fed ‘on hold’ going forward. However, the leash is on the shorter side with monetary policy now tilted toward a rate hike as the next move. While Warsh has de-emphasized forward guidance, the money and bond markets will still be looking to the annual August Jackson Hole Fed conference for clues as to what the Chairman is thinking.