Fed Chair Warsh signals a new era for rates and risk

As I write this, Fed Chair Kevin Warsh has just completed his speech at the annual Jackson Hole Economic Symposium, his first as the chair of the Federal Open Market Committee (FOMC). His comments are being taken by the capital markets as somewhat "hawkish" as the odds of a rate increase at the September FOMC meeting have moved up from around 30% to a 50/50 chance the Fed acts.

A key focus for Chair Warsh going forward is for the Fed to talk less, as he believes that the concept of "forward guidance" has outlived its usefulness. When the Fed uses its language to telegraph its future actions, the markets will "front-run" the action and price that outcome in today. In the recent past, forward guidance was generally towards lower rates, which meant the bond market would price in future rate cuts resulting in lower current rates. That is okay if the future turns out the way the Fed sees it, justifying their future actions. Unfortunately, as Chair Warsh pointed out in his speech today, the Fed has made some material mistakes in their forecasting. Anyone remember the Fed's statements that the inflation surge of 2022 was "transitory," which was why they kept rates at 0% for too long? For all their brainpower, complex econometric models and PhDs, the Fed's forecasting ability is far from perfect.

The result of forward guidance is that risks are priced out of the market. Importantly however, the risk does not disappear; investors are just no longer compensated for taking the risk. Hence as an investor, the environment Chair Warsh is describing is better. Getting compensated for risk means an investor can earn a higher rate of return whehn investing in, and holding, an asset. In the bond market, that means higher interest rates.

On the flipside, borrowers want lower rates. Forward guidance has been beneficial for them and a shift in policy may very well mean higher borrowing costs for consumers, businesses and public entities. So, isn't the idea of a new higher rate regime bad? A higher cost of borrowing could reduce the attractiveness of some projects, contribute to making home affordability more difficult and increase the interest cost burden of the federal government. However, the era of interest-rate repression led to suboptimal capital allocation decisions and the ability of some to borrow money with little or no cost. In the case of the latter, I am looking squarely at the federal government.

With all this in mind, our chart this week highlights another risk the Fed is taking if they misjudge the current environment and fail to act on increasing inflationary pressures. Historically, inflation has tended to come in waves. The chart overlays the inflationary period of 1966-1983 with the period from 2013 to today. You do not have to be a statistician to see a tight fit to today's environment nor an economist to say that we do not want the chart that will represent the current period to resemble the previous period. The medicine for inflation may not taste good, but we may need it.

Descargar el informe completo

Divulgación