Warsh delivers a boost to Fed's credibility

The Federal Open Market Committee (FOMC) delivered a 25 basis point (bp) rate hike, in line with market expectations, and Chair Warsh delivered a very solid and concise message. There was no mention of family fights or task forces; just a very clear and credible statement highlighting that inflation is above target and it will be brought down. It was credible not only because it was backed by a rate hike, but also by a dot plot that show Federal Reserve (Fed) officials are likely to raise rates one more time before the end of the year.

Paradoxically, this is good news for the long end. In our view there are two main reasons why the 10-year plus part of the curve could sell off dramatically. First, inflation that is out of control coupled with a central bank that is seen as unable and/or unwilling to bring it back to target. Second, erratic fiscal policy that leads to outsized budget deficits and a perception that the government is again unable and/or unwilling to balance the books at some stage. In our view, there were some doubts that the first one could take place given Chair Warsh's somewhat confusing communications previously. We think that yesterday's message takes this risk off the table for now. As for the second one, fiscal policy in the US is not getting any better and the war in Iran and floating plans such as giving voters money if the incumbent government wins the midterm election certainly does not help. Therefore, the risk still remains of a disorderly reaction in theory, but at least one of the potential causes has been removed from the equation for now.

Another way of looking at this is through the term premium. The 10-year US Treasury rate can be seen as a collection of short-term rate expectations for future years that compound over time for the next 10 years, plus a premium for the fact that investors are locking in an interest rate for that (long) period. If a central bank lacks credibility and investors have doubts about their ability or willingness to address inflation, they will require a higher premium for committing capital for longer periods. We think term premiums should have some respite after yesterday's decisions, although we highlight again that this is not the only factor that matters for term premiums.

Regarding monetary policy expectations, the dot plot shows that the most likely path is one further hike and then rates to remain at that level next year before some rate cuts in 2028 and 2029. This is less hawkish than market pricing suggests by looking at the short end of the curve. We tend to agree with the Fed that this is not a situation that requires a number of rate hikes in quick succession. We also believe that some optionality is needed due to the supply side nature of most of the inflationary shock in the US. In other words, if President Trump reached some sort of agreement with Iran and oil prices declined, then very quickly inflation would come down.

Which brings us to the last point we'd make: not all of the inflationary shock in the US is due to supply side issues. Strong economic growth has also contributed to inflation remaining above target and that can be seen in the fact that the Fed was not achieving its inflation mandate before the conflict started in March. This is one of the reasons why we like euro-denominated assets as a general comment. The European Central Bank had inflation at target and is experiencing a supply side shock. This gives us more confidence that few hikes are needed and these can be reversed relatively quickly once the supply side shock leaves the scene.

All in all, we think Chair Warsh delivered a much-needed boost to the Fed's credibility.  In our view, a restoration of credibility can only be a positive development.