• No change in Fed Funds range: 3.5% to 3.75%.
• Vote was 9 to 3 to hold rates unchanged; 3 votes to raise.
• Bottom Line: Fed on hold; confirmed focus on inflation

Round 2

Chairman Warsh is sticking to two of the three themes he listed in recent speeches. First, less communication. Today’s press release was virtually identical to June’s. Second, the statement affirmed that the Committee’s focus is on price stability. The third goal, reducing the Fed’s balance sheet, will have to wait, as today’s statement says that the Fed will continue to buy Treasury debt.

Three members did vote to raise the Federal Funds range by a quarter of a point. We think this signals to markets that the Fed is now ready to start a hiking cycle if inflation does not moderate. The Committee continues to believe inflation is being driven by supply shocks, namely crude oil prices.

In his press conference, Warsh did note twice that nominal and real interest rates have risen since the last meeting. He believes that the A.I. buildout is setting the stage for future growth. He likes that markets are paying more attention to economic and geopolitical events and less to the Fed. On that note, we are not sure markets have made that transition. We’ll see.

What's next

The Committee believes the economy is doing fine, but that inflation is too high. As a reminder “price stability” should mean very little or no inflation. Longer term inflation drivers are 1) a shrinking workforce demanding higher wages, 2) global competition (and war) for energy and resources, 3) money growth from Congress spending, and 4) efforts to re-shore and reinforce supply chains.

Taking Chairman Warsh at his word, we do not expect a surprise rate change baring an emergency. Markets took the three rate hike votes as a rate increase is coming soon and pushed longer rates higher. As of this writing, the two-year Treasury note, a sensitive barometer of possible Fed moves, has dropped by 5 basis points. That is not a big move and likely reflects short covering versus some view that suddenly the Fed is not focused on inflation.

Summary

We do believe Warsh and the Committee are committed to cutting inflation down to the 2% policy level. In the press conference, he stated that holding rates steady today was “the beginning of the story, not the end of the story.” Additionally, he said higher rates “could well be part of that solution.” That combined with the three hike votes sets the stage for coming rate increases.

The key, as always, is when. The M2 measure of money supply is running above 5% per year. Core services prices are rising for the first time in a decade. Energy prices are rising again thanks to news headlines and the fact that most developed countries have drawn down their strategic reserves this year. We think those headwinds will keep inflation pressures on the boil. Hedging in the futures markets suggest a better than 50-50 chance of a rate increase at the September meeting.

Warsh and the press release did little to address A.I. job concerns or the difficulties young people are having finding a job. Overall, the labor market is roughly in balance but help wanted signs are out in force in defense and manufacturing sectors. Credit card delinquencies are on the rise. Higher rates would not help consumers and home buyers.

Cutting the size of the Fed’s balance sheet by selling bonds has been a goal of market participants since the 2009 crisis. The Fed’s regular buying supports Congress’s habit of excessive spending and keeps bond prices higher than they otherwise would be. We think there will be no action to change the size or scope of the Fed’s bond holdings until the Task Forces give their reports. We understand they should arrive around Christmas.

Bottom line: we think a steady economy and strong capital spending gives the Fed a chance to wait and see. Warsh sounded hawkish without really saying anything substantial. We may be pulling at taffy on the quotes we cited above. Our markers for a rate increase are unemployment falling to 4% and CPI inflation hitting 4%. Until then, steady as she goes.

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Steve Orr is the Managing Director and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. Steve has earned the right to use the Chartered Financial Analyst and Chartered Market Technician designations. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here. 

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