Talk Less, Smile More

Research evidence excerpt

Talk Less, Smile More

IdeaMFinancial markets went into the July FOMC meeting thinking the Warsh-led Fed might

raise interest rates to establish its inflation fighting bona fides; in the weeks leading up to

the meeting it priced in more rate hikes, pushed real yields higher while keeping measures

of breakeven inflation low, and strengthened the dollar. It came out of the meeting

leaning entirely in the opposite direction, thinking that Chairman Warsh has a high bar for

rate hikes and could redefine the Fed's 2.0% inflation target in favor of something more

general and unspecified. As a result, prospects for rate hikes were reduced, the yield curve

steepened led by a sell-off in longer-dated yields, measures of breakeven inflation rose,

and the dollar weakened.

So which Fed is it? The point is we don't know and the chair isn't saying. Financial markets

will only do the Fed's work for it when it understands the Fed's objectives and how it will

respond over time. In other words, market movements, if accurate, ultimately need to be

validated by policy actions. When the central bank intentionally withholds information,

expectations can become less anchored: the Fed looks to markets for signals while

markets look to the Fed for direction. The result is what we saw this week: confusion,

volatility, higher risk premia, and a hit to Fed credibility.

As we discuss in more detail below, our outlook for inflation remains constructive and we

expect the Fed to stay on hold for the remainder of this year. However, risks to our

inflation outlook are to the upside and cannot rule out rate hikes later this year. The

added problem, as we see it, is that higher long-term yields reflect, in part, higher inflation

expectations.