A Good Family Fight

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The Fed embraced internal debate. Markets wanted clearer answers.

Federal Reserve Chair Kevin Warsh described this week’s policy meeting as “a good family fight.” The phrase captures both the debate inside the Federal Reserve and its increasingly complicated relationship with financial markets.

The Federal Open Market Committee left the federal funds rate unchanged at 3.50% to 3.75%. Three members preferred a 0.25% increase, producing a 9 to 3 vote and a meaningful level of dissent.

Warsh welcomed the disagreement, arguing that healthy debate leads to better decisions. He also reaffirmed that the Fed’s “North Star” remains price stability and returning inflation to its 2% target.

The Fed Was Comfortable. Markets Were Not.

Warsh appeared pleased with what had occurred in financial markets since the June meeting.

Longer term interest rates had risen, speculative areas of the stock market had weakened, and investors had begun pricing in the possibility that the Fed’s next move could be a rate increase rather than a cut.

In other words, markets had already done some of the Fed’s work.

That gave the committee room to remain on hold while tighter financial conditions slowed activity and restrained risk taking.

Investors, however, wanted more. They were looking for some indication of what would cause the Fed to raise rates, how close the committee came to acting, and whether a September increase should now be considered the base case.

They did not get those answers.

Stocks fell sharply during Warsh’s press conference. The Dow declined more than 1,100 points, the S&P 500 fell approximately 1.5%, and the Nasdaq dropped roughly 1.7%.

Markets rebounded Thursday, helped by strong Microsoft earnings and a sharp recovery in semiconductor stocks. The Nasdaq also snapped a six day losing streak.

That rebound was an important reminder that monetary policy is only one force driving markets. Strong corporate earnings and renewed enthusiasm around technology quickly shifted attention back toward company fundamentals.

The Communication Challenge

The market’s frustration should not have been surprising.

Warsh has said he wants investors to focus on the economy and incoming data rather than attempting to interpret every word from a Fed official.

His message has essentially been:

Play the ball, not the Fed.

True to that approach, Warsh did not explain the committee’s detailed thought process for keeping rates unchanged. He did not say how close the Fed came to raising rates, provide a roadmap for September, or clearly identify what would trigger its next move.

His comments were minimalist by design.

There is a contradiction at the center of that strategy. Warsh wants markets to stop obsessing over the Fed, but providing fewer explanations may cause investors to focus on it even more.

When investors understand how policymakers are likely to respond, markets can adjust gradually. When the Fed provides fewer clues, each inflation report, employment number, speech, and meeting can produce a larger reaction.

Less guidance does not necessarily mean less volatility.

It may mean more.

Wednesday’s selloff was not simply a reaction to unchanged rates. That decision was widely expected. Investors reacted primarily to what they did not hear.

The Fed remains committed to returning inflation to 2%, and three members wanted to raise rates immediately. Yet Warsh offered little explanation of why the majority preferred to wait or what would cause it to change course.

Markets do not like uncertainty, and Wednesday’s press conference provided plenty of it.

Our Take

The Fed’s decision to remain patient is defensible.

Financial conditions have tightened, and the committee will receive additional inflation and employment data before September. Raising rates simply to demonstrate resolve could create unnecessary economic damage.

However, patience comes with a cost.

The longer inflation remains above target, the more the Fed risks losing credibility. If households and businesses begin to accept 3% or 4% inflation as normal, expectations could become harder to control.

Warsh’s commitment to the 2% target is important. But at some point, words must be supported by policy.

For now, the Fed is asking investors to remain patient and evaluate the incoming data. Investors are asking the Fed to show more of its work.

That disagreement may be healthy. A good family fight can challenge assumptions and lead to better decisions.

But as anyone with a family knows, a fight becomes uncomfortable when no one clearly explains what they are thinking.

The Fed may be comfortable with that discomfort.

Markets clearly were not on Wednesday, although by Thursday strong earnings had given investors something else to focus on.

Key Takeaways

• The Fed left rates unchanged at 3.50% to 3.75%.

• Three members dissented in favor of a rate increase.

• Warsh reaffirmed the Fed’s 2% inflation target.

• Investors were disappointed by the lack of guidance about September.

• Microsoft earnings and a rebound in chip stocks ended the Nasdaq’s six day losing streak.

• Less forward guidance could create more short term volatility.

• Bond Yields Chased Oil Prices higher

• The Fed’s credibility will ultimately depend on results.