Markets expect the Fed to hold rates in October. Kevin Warsh could surprise them — analysis

Traders are betting overwhelmingly that the Federal Reserve won’t raise interest rates when it meets later this month. But that judgment rests in part on assumptions about how the Fed communicates that may no longer hold under its new chairman. Kevin Warsh has left room to maneuver toward a hike, should he choose to use it.

To be clear, Warsh said outright at an International Monetary Fund event in Bangkok Friday morning that he wasn’t signaling a decision one way or the other. His remarks nonetheless reinforced a judgment in the markets that the Fed would pause its rate increases, with the futures market assigning a 15% probability to an October hike as of Friday morning. That judgment follows remarks by other Fed speakers, including the chair’s traditional top lieutenants, who indicated they were comfortable holding.

There are good reasons for investors to expect the Fed to wait. But there is also a case in the inflation data that Warsh could invoke to push the Federal Open Market Committee toward an increase on Oct. 28. Investors are overlooking that case based on longstanding past experience with the Fed. 

But the chairman has repeatedly rejected the convention of telling markets what he plans to do before the committee meets. That raises the possibility that investors are dangerously complacent about the probability of a rate hike in October.

That complacency rests on a few bases. One is that the chairman’s top lieutenants speak for him, or at least wouldn’t contradict him in public. That was true in the past, but may not be so anymore.

In recent weeks, both Fed Vice Chairman Philip Jefferson and New York Fed President John Williams gave remarks that indicated they see little urgency in raising interest rates. The markets quickly repriced in favor of a hold in October.

Warsh, Jefferson and Williams make up an informal decision-making team atop the Fed known as the troika. Warsh could arguably coordinate with the troika even if he doesn’t believe in communicating his own views. But outsiders can’t be certain that traditional conventions surrounding the public statements of the New York Fed president and the Fed vice chair have survived the leadership transition.

Another assumption is that Warsh broadly accepts the FOMC’s view of the economy. “The world has broadly conformed to our expectations,” Warsh said in Bangkok of the economy since September.

That can be read as saying that relatively hot inflation readings from the consumer and producer price indexes in recent days don’t disconfirm the view expressed in the Fed’s most recent Summary of Economic Projections released at the conclusion of the September meeting. At the time, the median Fed official believed there would be one more rate hike in 2026 — which left room to pause in October and raise again in December. 

But Warsh went out of his way at the September press conference to disclaim the SEP. “Those aren’t my forecasts,” he told a reporter. 

Warsh set out his own idiosyncratic reading of the economy in detail at a closely watched speech in Jackson Hole, Wyoming, at the end of August. It described the economy as growing strongly, with inflation a greater worry than the jobs market. Warsh’s strongly hawkish views then set up the FOMC to unanimously raise interest rates in September. That hawkish position relied heavily on what he sees as loose credit conditions. 

The Chicago Fed’s National Financial Conditions Index has risen about 0.05 points since Jackson Hole but remains negative, indicating financial conditions have tightened but remain loose overall. 

Does Warsh believe the market has done his work for him? Is having “removed a dose of accommodation,” as he put it Thursday, enough? We can infer these answers, but we won’t really know them until the FOMC press conference.

Then there is the inflation data. The consumer price index rose 3.7% for the year through September, while the producer price index gained 6.3%. The new data implies that the next reading of the Fed’s preferred inflation reading, core personal consumption expenditures, will come in at 3.1% year over year. Headline PCE, which will be affected by energy prices, would be higher.

Warsh has gone out of his way to say that figures at that level are a problem. After economists questioned whether Warsh might tolerate inflation above 2%, he was unequivocal in Jackson Hole: “There should be no misunderstanding,” Warsh said. The Fed’s 2% PCE goal “is a firm, fixed target.”

Warsh is visibly learning on the job. He may well be coming to understand that the Fed chairman can’t operate alone and must rely on the staff and the rest of the FOMC to help him do his job. Likewise, he may discover that markets don’t issue a clear signal independently of the Fed. 

Raising rates while the markets strongly expect otherwise is a recipe for volatility. That factor has prompted interventions by officials like Jefferson and Williams in the past. A surprise decision after they were seen to guide the market could dent their credibility and make the Fed’s decisions even harder to predict.

But how Warsh will settle these matters isn’t clear yet. Warsh could go into the October meeting primed to muscle up wavering committee members based on booming demand for AI spending and warm readings in the inflation data. Or he could sit back and tack toward the middle of the committee once he assesses its views. 

Warsh still has the potential to surprise us, and it’s risky to assume otherwise.