What happens when Fed credibility comes under pressure?

The latest Federal Open Market Committee (FOMC) meeting left a strange taste on investors' mouths. In our view, Chair Kevin Warsh failed to clarify the Federal Reserve’s (Fed's) reaction function and the central bank’s views on the current economic picture and relating to monetary policy. After a selloff in government bonds and volatility in risky assets (not helped by Situation Awareness's mini meltdown), markets seem to have moved on to the next catalyst, a potential deal between the US and Iran.

While it is understandable that markets have moved on, we believe some doubts may have been planted about the Fed's credibility, which could have longer lasting effect if not addressed at an upcoming FOMC meeting. There have been various articles in the last few days discussing this topic, highlighting how credibility is a central bank's most precious asset. It is hard earned through numerous good decisions, yet it only takes a couple of bad ones to put it at risk. While we agree that part of the move higher in the curve might have been due to the lack of clarity, and this is consistent with a continued rise in certain measures of term premia, we tend to think that, with a medium-term hat on, the market has not even begun to price in a potential erosion of the Fed's credibility.

This is both good and bad. It is good in the sense that markets still believe the Fed is not asleep at the wheel. But it is bad in the sense that nominal rates have a long way to go if the Fed’s credibility is indeed challenged. If credibility was really under pressure, we should see an increase in inflation expectations.

As shown below, the bulk of the move higher with 5-year US Treasury yields, can be attributed to a rise in real yields. While inflation expectations have remained "in the range" and are now at just over 2%. Were investors worried about the Fed's ability or willingness to keep inflation under control, then 5-year nominals would have moved further upwards due to a rise in inflation breakevens.

There were solid reasons why an FOMC voter might have voted to hike last week: inflation is above target, the economy is showing a decent performance, and the labour market is not under pressure. Conversely, there are a few bullet points in the "hold" list: oil prices going higher is a supply shock against which the Fed cannot do much, the housing market is stagnant, and rates are above what most of the FOMC considers to be the neutral rate (although focusing too much on dot plots seems like a distant past). The problem was that the rationale for the decision was not well explained; therefore, the market is unsure about the Fed's reaction function, which in turn makes it impossible to judge exactly when inflation might fall back to target. Is Chair Warsh focusing on current inflation? Or is he more worried about the trend moving in the right direction? Is personal consumption expenditure (PCE) inflation likely to be the main number to look at? We simply cannot tell.

The problem might be exacerbated by Chair Warsh's determination to extract clear, unbiased signals from markets, instead of providing investors with an anchor in the form of a clear view of the economy and a predictable reaction function. Isabel Schnabel, member of the European Central Bank’s (ECB's) Executive Board, delivered a related point in a speech back in 2024 on real rates, where she cited research that showed how central banks’ communication might have a larger impact on real rates than previously assumed.

Her conclusions are particularly relevant, where she states: "That said, the uncertainty about how central bank actions and communication affect real long-term rates suggests that policymakers need to tread carefully. Rather than looking to financial markets, which could just be a mirror of ourselves, we need to thoroughly examine whether the fundamental forces driving the economy over the long run have changed and communicate these views prudently." This is the exact opposite of what Warsh's Fed seems to be doing, which does not seem to sit well with other Fed officials such as Christopher Waller who has been quite explicit about his own reaction function.

Markets are not showing signs of losing faith in the Fed's ability or willingness to bring down inflation to target at this stage, but the stakes are high. Making significant changes to organisations at a time when objectives are not being achieved is risky business, and looking for market signals to inform the Fed's decisions might backfire. There were reports that Warsh was toying with the idea of reducing the number of FOMC meetings, of which there are currently eight per year. We think this would be a mistake and might erode the Fed's credibility.

Given the marked selloff in US Treasuries in the last few weeks, we are not inclined to reduce dollar duration at these levels. However, the potential resurgence of Fed credibility issues has seen our view shift, from one where we would be more inclined to buy the dips in US Treasuries, to one where we would rather sell the rallies. With inflation expectations at just over 2%, any sustained rally in US Treasuries has to come from real rates declining. While real rates have been volatile, a significant move lower should be accompanied by some sort of growth scare or a positive surprise on the US Treasury issuance front. Neither looks likely at this stage.