Markets are set for a much more hawkish Warsh Fed than expected

• Fed Chairman Kevin Warsh's tough talk on inflation reverberated through financial markets, with traders expecting that the central bank could start jacking up interest rates in just a few months.
• A popular narrative that Warsh was sent to the Fed to ease monetary policy at all costs was quickly dispelled within the space of a 40-minute news conference with reporters.
• "What I think we're seeing is regime change, but in a velvet glove," said Scott Clemons, chief investment strategist at Brown Brothers Harriman.

In this article

• US2Y

Federal Reserve Chairman Kevin Warsh's tough talk on inflation Wednesday reverberated through financial markets, with traders expecting that the central bank could start jacking up interest rates in just a few months.

Tapped to serve by President Donald Trump, who has repeatedly demanded lower rates, Warsh during a news conference instead focused on the battle against inflation, which has run above the Fed's official 2% target for five years.

"Persistently high prices are a burden for the American people, but the recent past need not be prologue," he said. "I am pleased to report that members of the [Federal Open Market Committee] are unambiguous and unanimous. This committee will deliver price stability."

Markets immediately took notice as the new central bank leader sought to establish his inflation-fighting credentials.

The 2-year Treasury yield, seen as a market reflection of Fed moves, soared as Warsh spoke.

At the same time, futures market traders began placing bets on when the next rate hike would come. The probability for an increase at the July 28-29 meeting quickly climbed to about 1 in 3. Odds for a September hike spiked to 67% around midday Thursday, according to the CME Group's FedWatch gauge.

Dispelling the Warsh narrative

Moreover, traders priced in largely tighter Fed policy well into the future, too.

The odds of a second hike by September 2027 rose above 45%. Even further out, the market-implied fed funds rate for May 2031 stood at 4.78%, indicating as many as five hikes in as many years from the current target range of 3.50%-3.75%.

A popular narrative that Warsh was sent to the Fed to ease monetary policy at all costs was quickly dispelled within the space of a 40-minute parley with reporters. At times serious and other times light-hearted, the session was notable for the inflation focus, with Warsh referring to "price stability" a dozen times.

Market veteran Ed Yardeni said he was "blown away" by Warsh's remarks.

"We thought he was a dove who favored lowering the federal funds rate (FFR) because he believes that AI is boosting productivity and economic growth while keeping a lid on inflation," the head of Yardeni Research said in an overnight note. "Instead, he hammered home a strict, orthodox message on inflation with a strong commitment to price stability."

The pivot to inflation fighter shook investors, with stock market averages diving along with the spike in Treasury yields.

But apprehension about a possibly hawkish Warsh Fed dissipated Thursday as Wall Street digested the FOMC meeting outcome and focused more on positive developments in the Iran war and the prospect for lower energy costs ahead. Stocks rallied and yields were flat to lower.

Some positives on inflation

There seems reason for optimism that the chairman's position in retrospect could be seen as a good deal of saber-rattling amid what might already be positive prospects for inflation. Even with popular inflation gauges at multiyear highs and well above the Fed's 2% target, underlying pressures are easing, with core inflation up just 0.2% in the month in May.

Scott Clemons, chief investment strategist at Brown Brothers Harriman, thinks the Fed actually won't make any moves this year on rates as it watches the shifting inflation dynamics and other factors play out.

"Far be it for me to disagree with the futures market, but I would be surprised if the Fed raises interest rates this year," Clemons said. "It is an election year. This is already a hyper-politicized environment. There's already concerns about politicization at the Fed. I'm not sure they want to feed that."

In the past, Warsh has said it's generally prudent to look through temporary supply disruptions that hit prices.

Commodity costs, in fact, are up just 6% since the war began in late February and have come off their May peak by some 17%, as measured by the S&P GSCI index. Should inflation ease and commodity prices continue to retreat — the price of gasoline dipped below $4 a gallon Thursday, according to AAA — and the economy wobble, that could get the central bank back into an easing posture.

"For now, for the markets, Warsh's message was comforting and unsettling," Steve Blitz, chief U.S. economist at TS Lombard, said in a note. "In declaring that inflation will be dealt with in no uncertain terms was comforting. By saying that markets will decide where to set rates rather than having them set with an eye to where the Fed wants them set was unsettling (to today's traders, but this should, ultimately, prove comforting)."