Federal Reserve Chairman Kevin Warsh has been talking a big game for months about fighting inflation, but failure to signal an intention to follow through soon has Wall Street questioning his commitment to price stability.
Markets didn’t react immediately after the Fed announced no change to rates on Wednesday as investors had largely bet policy would remain steady. Instead, Warsh’s comments during his post-meeting press conference sparked a selloff in Treasuries that sent yields sharply higher.
He has vowed “regime change” at the Fed by rolling back so-called forward guidance on where rates are headed and offered no such clues on Wednesday, even talking around no-brainer questions on how to bring down inflation.
Other hints on how he might change the way the Fed operates rattled nerves further. Warsh indicated an openness to other inflation gauges besides the Fed’s preferred metric and suggested there could be tools other than rate hikes to fight inflation. He also implied that higher yields have already done some of the Fed’s work for it.
But this backfired, resulting in what Aditya Bhave and the U.S. economy team at Bank of America called a “central bank inflation credibility shock.”
“Ironically, we think the need to re-establish credibility increases the probability that the Fed will hike in September, all else equal,” he added in a note on Wednesday.
In other words, Warsh’s remarks were so dovish that they will likely force a hawkish outcome, meaning other members of the rate-setting Federal Open Market Committee must pick up the pieces.
JPMorgan economist Michael Feroli said in a note that the new chairman’s comments about looking beyond the Fed’s preferred inflation gauge in particular likely didn’t sit well with everyone else on the FOMC.
“It is those members who we believe will vote to take action to deliver on the institution’s mandate,” he wrote.
A major test for the Fed will come on Friday, when the Labor Department will report monthly payroll data. Fresh signs that the job market remains robust could fuel more worries about inflation.
BofA pointed to the bond yield curve as an indicator of the central bank’s perceived commitment to reining in inflation.
If Wall Street expects rate hikes are coming soon, short-term yields will jump. But long-term yields will fall as investors price in lower inflation in the future. That flattens yields across maturities. If markets doubt the Fed, however, the short end will fall while the long end surges.
“Flattening of the curve would mean markets still believe the Fed will do what it takes to meet its mandate,” economists said. “But if the curve were to steepen on strong jobs/inflation data, that would indicate the Fed is behind the curve, raising more serious questions about its credibility.”
Backing up tough talk with actual details on how to make inflation go lower is key to the Fed’s credibility, according to Apollo Chief Economist Torsten Slok.
In a note on Saturday, he drew an analogy to a hypothetical promise to take someone from New York to Los Angeles—without saying how long it will take, what it will cost, or how you’ll get there. That will inevitably raise questions about how real the trip is.
“The risk with abandoning forward guidance is a steeper yield curve with investors asking more questions about the journey ahead, which is what we have seen since the statement came out,” Slok added. “The bottom line is that an important part of the Fed’s credibility is not just to say that it has certain goals but also to explain how it will achieve those goals.”
