Federal Reserve credibility strengthens as Warsh signals inflation fight

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Fed credibility on inflation

Highlights

Ten-year break-evens fell from above 2.5 per cent in mid-May to about 2.2 per cent this week, reflecting a hawkish Fed and lower oil prices.
May Personal Consumption Expenditures Price index inflation rose to 4.1 per cent, with core PCE inflation increasing to 3.4 per cent, both above the Fed’s 2 per cent target.
Despite persistent inflation, market-based expectations now price at least one Fed rate hike this year after the Iran war resolution and hawkish Fed signals.

Market response to hawkish Fed signals

As reported by Financial Times, ten-year break-evens, which reflect the bond market’s view of long-run inflation, have fallen from above 2.5 per cent in mid-May to about 2.2 per cent this week, their lowest level in more than a year. Investors say the decline reflects both the recent drop in oil prices to levels last seen before the start of the U.S.-Iran war and the Federal Reserve’s hawkish turn at its meeting last week, where Warsh described persistently high prices as a burden for the American people.

The tougher tone has eased worries that Warsh might bow to pressure from Donald Trump to lower interest rates after the U.S. president repeatedly attacked former chair Jay Powell for keeping borrowing costs too high. Mike Riddell, a fund manager at Fidelity International, says the decline in long-term break-evens is greater than oil moves alone would suggest, adding that the Fed’s hawkish tone has given the central bank more inflation-fighting credibility with the market.

Data released on Thursday underline the challenge facing Warsh. Inflation rises to 4.1 per cent in May on the Personal Consumption Expenditures Price index, more than double the Fed’s 2 per cent target, while core PCE inflation, the Fed’s preferred gauge of longer-term price pressures, also edges up to 3.4 per cent.

Rate path and broader policy implications

Despite current price pressures, market expectations of future inflation edge lower this week. A swap measuring average inflation over the coming 12 months, starting in a year’s time, falls by 0.12 percentage points to 3.88 per cent.

Jon Hill, head of U.S. inflation strategy at Barclays, says the combination of the hawkish Fed meeting and the tentative resolution to the Iran war lowers perceived inflation risks and leads to a sharp fall in market-based measures of inflation expectations. Even after the deal between Washington and Tehran to restore the flow of oil through the Strait of Hormuz, traders continue to bet on at least one quarter-point rate increase from the Fed this year, reversing expectations for a series of cuts that had prevailed before the war began in late February.

Krishna Guha, vice-chair at Evercore ISI, says Warsh may avoid raising rates if inflation broadly improves by September while maintaining a tough stance. But he warns that if the data do not begin to move clearly in that direction by September, the Fed chair will have to raise rates or risk losing credibility.

Some investors and economists also argue that the Fed may not need to deliver many increases if Warsh succeeds in convincing markets he is an inflation hawk, thereby lifting borrowing costs through market pricing. Aaron Rock, head of rates at Aberdeen, says it remains unclear whether Warsh is talking tough partly to avoid ultimately having to raise policy rates.

In our earlier article on Carnival (CCL), we examined how the company’s record Q2 revenue and renewed capital returns were overshadowed by weaker forward guidance tied to softer Mediterranean demand amid the Iran war. We also highlighted bearish technical signals and a base-case consolidation range, reflecting cautious sentiment despite improved balance-sheet metrics.

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