Investors heartened by Warsh inflation talk, still uncertain about Fed action

Investors were heartened on Friday by new Federal Reserve Chair Kevin Warsh's stated resolve to tame high inflation, but many on Wall Street remained unclear about how the U.S. central bank will react to economic changes in the months ahead. In a highly anticipated speech, Warsh said the central bank will "have work to do" if policymakers are not confident that underlying inflation is returning to its 2% target. He also indicated financial conditions do not appear restrictive and came closer than previously to acknowledging that interest rate hikes may be needed to ease price pressures.

Since starting as chair several ‌months ago, Warsh has ⁠made clear he ⁠plans to pare back the Fed's communications, including no longer indicating the central bank's interest rate path through forward guidance, a position he re-emphasized on Friday.

But investors were hopeful that Warsh's address at the Jackson Hole, Wyoming, symposium would ​convey enough to shore up confidence in his leadership and the Fed's commitment to controlling inflation. Investors say Warsh had sown market confusion and stoked doubts about his credibility on inflation in part ​by hinting at last month's policy meeting that rising yields, by tightening monetary conditions, could reduce pressure on the Fed to hike rates.


"Warsh was certainly clearer than he was in July," said Phil Blancato, chief market strategist at Osaic. "We now have a better understanding of where he wants inflation to go, but relatively little guidance on what combination of inflation and labor ​market data would cause the Fed to act."

HAWKISH RESPONSE TO WARSH'S REMARKS

Markets suggested a hawkish take on ⁠Warsh's speech. The ‌U.S. Treasury 2-year yield, which typically moves in step with Fed interest rate expectations, rose to 4.34%, its highest level in a month.

The 30-year ​U.S. Treasury yield was little changed ​at 5.19%. That long-term yield has recently risen to its highest level in nearly 20 years, causing investor unease ahead of the remarks.

Warsh's ⁠speech "should quell some of the bond market anxiety as he gave a clear picture of the Fed's ​stance on inflation and the need to push it down to target at sufficient speed," said Cyrus Amini, chief investment ​officer at Hyphen Wealth Management.

The benchmark S&P 500 stock index was last down 0.3% on the day, while the U.S. dollar added to gains against a basket of currencies.

SEPTEMBER RATE HIKE ODDS RISE

Inflation for several years has consistently run above the Fed's 2% annual target. Data this week showed the Personal Consumption Expenditures Price Index, which the Fed uses to set its target, increased 3.7% in the 12 months through July.

Fed funds futures on Friday suggested a 57% chance of a rate hike at the next meeting in September, up from 35% odds just before Warsh's speech, according to LSEG data.

"Warsh was more hawkish than expected from the marketplace," said Chris Gunster, head of fixed income at Fidelis Capital.

Still, not ‌every investor was convinced a rate hike in September was a done deal. Warsh has set in motion plans to potentially revamp the Fed, establishing task forces to review areas such as the Fed's use of its balance sheet, what data it uses and its framework for dealing with ​inflation.

"I still think that ​there's plenty of room here for him to operate," ⁠said Michael Arone, chief investment strategist at State Street Investment Management. "I haven't concluded that they're going to raise rates."

'REACTION FUNCTION' REMAINS UNCLEAR TO SOME

Warsh's comments "should be seen as an effort to push back against the criticisms that were leveled after his first two press conferences," said Karl Schamotta, chief market strategist at payments company Corpay in Toronto.

"He reduced ​ambiguity around the Fed's preferred inflation target, stressed the role of short-term interest rates in transmitting policy and avoided any suggestion of leaning on markets to do the job," Schamotta said.

But while Warsh acknowledged the economy was "running hot ... he was reluctant to say how to get things cooling off a little bit," said Sonu Varghese, global macro strategist at Carson Group.

"I would have liked a little more explanation of that reaction function," Varghese said.

Investor focus on the path of monetary policy now turns to impending U.S. economic data releases, starting with the monthly jobs report next Friday and the consumer price index due the following week.

"The stakes ahead of the August payrolls and inflation reports are now very high," Schamotta said.