The Fed dysfunction continues

Trump was happy to see Powell leave and probably had high hopes that the Fed would jump start the economy. The Fed struggled with decision making during Covid and let the inflation sprint to close to 10% before taking action, raising the interest rate. Prices across the board went up and affordability become a key election issue. Had the democrats had a more qualified candidate than Kamela Harris and on top of that with the far-left Tim Walz, they likely would have won the presidency. Affordability is still the main concern heading into the midterm elections in November. The situation is the same for the democrats; the main problem is their weak candidates. Despite high prices, the Fed seems paralyzed.

The Federal Open Market Committee of the Federal Reserve meets every eight weeks to set interest rates, specifically the federal funds rate, the overnight rate at which banks lend each other money. The Fed funds rate has little direct economic significance, since nobody making important investments relies on overnight money. But an upward or downward change in the Fed funds rate tends to drag longer-term rates up or down with it. Even more important, FOMC decisions, along with their public statements, affect the market’s expectations about future monetary policy.

Setting such expectations is one of the major roles of the Fed. So FOMC decision days are something of a theatrical performance. The committee does not just announce its interest rate decision. It releases a statement explaining that decision; then the Fed chair holds a press conference, in which he or she tries to build credibility by answering reporters’ questions. Market traders closely analyze these statements in order to predict the future direction of inflation and monetary policy. As a result, FOMC decisions and statements have critical influence over current market rates.

This week, Kevin Warsh, who Trump selected as Fed chair, played the starring role. His job was to explain why the Fed did not raise rates in the face of inflation that is persistently well above its 2% target. Trump still wants the Fed to lower rates to grow the economy and make investments cheaper. That would drive prices and inflation higher though. The bond market, the ultimate reviewer, really did not like Warsh’s performance. The 30-year Treasury rate spiked and the dollar fell slightly. In plain English, this was the equivalent of bond market traders running for the exits.

At 3.7%, inflation has been persistently well over the Fed’s 2% target rate, largely as a consequence of Trump’s tariffs, which have raised the prices of imports, and the Iran war, which has caused energy prices to soar. The Fed normally raises interest rates to fight inflation. But it instead left rates on hold in this meeting.

The Fed might view the current situation as temporary. When a spike in inflation is temporary and will soon fade away from its own accord, the Fed tries to look through this temporary shock and not base interest rate decisions on it. Both the Trump tariffs and the energy price spikes are arguably one-time events. But whether the inflation shock is truly transitory is not certain. Three of the FOMC’s 12 members dissented and called for a small rate hike. And it’s important to note that three dissents are a lot. This was the first time since 1970 that a new Fed chair faced three opponents to an early interest rate decision. But the bond market was rattled. Its reaction indicated that traders believe that there is a good chance that the Fed is going to keep rates too low for too long and thereby feed inflation. As a result, the Fed will eventually be forced to raise future rates to a higher level than if it acted to rein in inflation now.

It seems that the bond market reaction was not a judgment on the rate decision itself. It was, instead, a judgment on Warsh. In other words, Warsh’s remarks on Wednesday led the market to distrust his commitment to fighting inflation. Many media reports are describing Warsh as a monetary hawk. That is a category error. Warsh is a political animal. He has been all for lower interest rates since November 2024. Warsh did not necessarily need to advocate a rate hike. But he has harshly denounced the Fed for acting too slowly to tame inflation in the Biden years. Now he finds himself in a similar situation, so at the very least he needed to explain clearly why he thinks this time is different. Instead, his performance at the press conference was stumbling, confusing, and evasive.

One interpretation of what happened is that markets understand the Fed’s commitment to 2% inflation, but with no forward guidance, the market does not understand how the Fed will get to 2% inflation. Is the way to 2% inflation through higher rates, a smaller balance sheet or tighter financial conditions? The answer to this has significant implications for the yield curve and how and when we will achieve 2% inflation. The lack of clarity about how to get there is what is pushing yields higher because there is now a risk that it may take longer or involve a policy mistake. The bottom line is that an important part of the Fed’s credibility is not just to say that it has certain goals but also to explain how it will achieve those goals. The dysfunctions appears to continue and the real losers are the American voters.