Breitbart Business Digest: Wall Street Is Daring Kevin Warsh to Raise Interest Rates

The Economic Case for an October Hike

A Fed Hike Could Break the Market’s Fedamentalism

Last week, Federal Reserve Chairman Kevin Warsh appeared at the International Monetary Fund’s annual meeting in Bangkok and reiterated his refusal to tell investors what the Fed plans to do with interest rates.

“I don’t prejudge meetings. I don’t believe in saying now what I might do at the meetings we have in the balance of this year,” Warsh said. “It’s a new chapter at the Fed, and we’re not in that business anymore.”

Wall Street’s response was to become even more convinced that it knew what the Fed was going to do. Before Warsh spoke, fed funds futures indicated around a 72 percent chance that the Fed would leave rates unchanged at its October meeting. Afterward, the probability of a hold climbed above 85 percent. As of Thursday evening, the probability of a hold is up to 95 percent, a record high expression of certainty a little less than a week before the Fed meeting.

In other words, Warsh told investors he wasn’t providing forward guidance, and investors decided this was guidance that the Fed would not raise rates.

It’s an impressive trick. Wall Street has apparently become so accustomed to the Fed telling it what to expect that it can now hear the Fed telling it nothing and interpret this as confirmation of what it already expected.

The problem for investors is that the economic data have been making an increasingly compelling case for another interest-rate increase.

The Fed raised its benchmark rate by a quarter percentage point in September, bringing the target range to 3.75 to 4.00 percent. Most Fed officials at that meeting anticipated that another increase would be appropriate before the end of the year.

Since then, the inflation picture has deteriorated considerably.

The consumer price index rose 0.6 percent in September and is up 3.7 percent from a year earlier. Producer prices jumped 1.3 percent for the month and 6.3 percent over the year. More troubling, inflation has been spreading beyond energy. Core consumer prices rose 0.3 percent, while producer prices excluding food and energy climbed 0.7 percent.

And the economy is hardly showing signs of buckling under the weight of higher interest rates. Consumer spending has remained resilient, business investment is booming, and American factories have been increasing production of machinery, electrical equipment, and semiconductors. The Conference Board’s Leading Indicators, which were released Thursday, show signs of an economy strengthening, not weakening. Jobless claims fell to 194,000 for last week, and the three-month average of claims is the lowest it has been since 1969.

There’s a reasonable argument that the Fed’s current policy rate is not particularly restrictive in an economy with this much momentum. If the natural rate of interest has risen because of stronger productivity growth and investment demand, the Fed may need to maintain higher rates to keep inflation under control.

And with inflation accelerating, why should the Fed wait until December to raise rates again?

The Fed’s Forward Guidance Trap

There is, of course, a reason to wait. Financial markets are so convinced that the Fed will hold steady in October that a hike would come as a substantial surprise. The meeting also falls just six days before the midterm elections, raising the political stakes of an unexpected move.

Under the old Bernanke-Yellen-Powell Fed regime, these considerations might have been decisive. Fed officials spent years cultivating the idea that markets should rarely be surprised by monetary policy decisions. When markets misunderstood the Fed’s intentions, policymakers typically tried to correct expectations before the meeting. So if you went into the blackout period with the market pricing in a Fed hike or a pause or a cut, then you could be damn sure that the Fed was going to do what the market expected.

But Warsh has explicitly rejected that approach. He believes the Fed should respond to economic conditions as they develop instead of attempting to manage expectations about decisions it has yet to make. He doesn’t want the market constantly looking to Fed speeches to predict the Fed’s next move. He wants us looking at things like underlying inflation figures and the strength of the labor market. He wants fundamentals not fedamentals to be the focus.

But announcing the death of forward guidance seems like it may not be enough to kill fedamentalism.

Investors have developed an elaborate habit of interpreting every speech, interview, and Q&A period comment as a clue to future policy. They pore over texts of Fed speeches like they were trying to find the true name of the divinity. When Warsh refuses to play along, they simply interpret his silence as another clue. Forward guidance has become something of a ghost haunting the bond market.

Kevin Warsh: The Exorcist

An October hike would provide an unusually effective exorcism.

It would also demonstrate that the Fed is prepared to respond forcefully to renewed inflation. That could even help bring down longer-term Treasury yields if investors became more confident that inflation would be contained. Lower long-term rates would be welcome news for the battered housing market and companies attempting to finance the enormous AI investment boom.

Of course, Warsh shouldn’t raise rates merely for the pleasure of surprising Wall Street and watching bond traders squirm and squeal. While such pleasure would no doubt be exquisite, the humiliation of Masters of the Universe is not an altogether sound basis for monetary policy. The economic case for an increase has to carry the decision. But if Warsh concludes that another hike is warranted, he probably will not let the market’s expectation of a hold stand in the way.

Wall Street says the Fed won’t raise rates next week. Warsh has been telling Wall Street that it doesn’t know what the Fed will do. The market is overconfident that it can still play “watch the Fed” instead of “watch the economy.” Warsh may want to shake that up.