MNI FED WATCH: Long End Yields Rise After Warsh Holds Rates

Long bond rates rose Wednesday after Federal Reserve Chairman Kevin Warsh welcomed materially tighter financial conditions in the absence of Fed action and equivocated on whether PCE inflation would remain the Fed's official target after an external review. 

Three hawkish dissents to the July FOMC decision to maintain benchmark interest rates at 3.5%-3.75% also signaled a committee prepared to raise interest rates later this year should inflation remain elevated. Traders had priced a one-in-three chance of a hike Wednesday, making this the most uncertainty Fed meeting in years. (See MNI INTERVIEW: Fed To Consider Hike in Sept - Lockhart)

At his post-meeting press conference, Warsh counseled patience and repeatedly reassured reporters that this FOMC is eager to deliver on Congress's remit and reform how the Fed conducts policy. 

He hailed the recent jump in nominal and real yields -- without any policy shift and minimal forward guidance from the Fed -- as offering a positive signal that the FOMC is on the road to restoring price stability after five years of above-target inflation.  

"Prices reacted in real time to incoming information and the reduction in forward guidance may have been a factor. Market participants are learning to play the ball, not the referee, and market prices will continue to respond in the direction and magnitude they see fit. This is, in my view, a change for the better, and we're just getting started," he said.

A noncommittal comment on the Fed's official yardstick to measure inflation added to the rise in long term yields and fall in the dollar and stocks. 

Asked which measure he uses to assess inflation, Warsh cited the official PCE inflation gauge but added: "Who knows come after next January what we might say about strategy? I suspect the task forces might have something to add." To achieve 2% inflation, he said, "I'm looking at a broader set of inflation data than PCE." (See MNI POLICY: Warsh Task Forces Will Need To Woo FOMC Skeptics)

ANCHORING EXPECTATIONS

As expected, Warsh refrained from tipping his hand on rate hikes, saying it's only one part of the toolbox. Reestablishing the inflation target at 2% is another priority, he said.

"If inflation continues to be elevated through the forecast period, interest rates could well be part of that solution, but I wouldn't say it's in isolation," he said. 

Financial markets, households and businesses may have had the "misimpression" that the Fed was tolerant of a somewhat higher inflation target, he said. So another tool to achieve price stability "is to ensure that expectations are centered around the right number and I think we made some progress on that." 

The FOMC has been focused on trying to understand and identify underlying inflation dynamics amid shocks, including whether the AI-related capex boom that's driving up prices of memory and logic chips indicates a broader inflationary dynamic, Warsh said. 

He added the timing and magnitude of supply-side effects of the AI boom remains hard to predict. 

"We take these shocks seriously. There have been a series of them that have been hitting this economy. We're not looking through them and saying, oh they don't matter, but we're trying to understand to what extent are these shocks broadening in their effects, broadening in their impact on prices that are quite far removed from it," he said.