FOMC meeting, July 28-29

Letting markets take the reins

• The Federal Reserve kept the federal funds rate unchanged at a target range of 3.50%–3.75%, despite markets pricing a 35% chance of a hike. The accompanying 131-word statement failed to provide any meaningful sense of the Fed’s reaction function, containing little beyond a backward-looking description of recent economic data and a renewed commitment to price stability. As telegraphed in recent communications, Dallas Fed President Lorie Logan and Cleveland Fed President Beth Hammack dissented in favor of a 25 basis points (bps) rate hike. They were joined by Minneapolis Fed President Neel Kashkari.
  
  
• We previously believed the Fed would remain on hold through year-end, but that call is looking increasingly fragile. Not because Chair Kevin Warsh is signaling any imminent tightening — he is not — but because he appeared willing to let financial markets do part of the tightening while allowing the committee’s collective judgment to guide the policy decision. That strategy risks being overtaken by an increasingly hawkish Federal Open Market Committee (FOMC). If inflation remains elevated, with pressure stemming from the Middle East conflict, tariffs or AI, the committee may ultimately force a rate hike that the Chair himself does not appear eager to deliver.
  
  
• Markets were left confused — and somewhat concerned — after the press conference, with the odds of a September rate hike falling from close to 100% to around 65%. At the same time, the 30-year Treasury yield surged 10bps to above 5.2%, suggesting lingering doubt about the Fed Chair’s credibility in delivering on his resolute commitment to return inflation to target.
  
  
• Our base case has been that the Fed could remain on hold through year-end, as monthly core personal consumption expenditures (PCE) readings around 0.2% month over month (m/m) are entirely plausible. But the FOMC’s margin of inflation tolerance — excluding Warsh — now appears so narrow that any meaningful inflation miss could force a September hike. In that regard, New York Fed President John Williams and Fed Vice Chair Philip Jefferson are key policymakers to watch.
  
  
• This is despite our belief that rate hikes would not be the optimal policy prescription for inflation driven primarily by supply shocks, including the Middle East conflict and tariffs. And while AI-related price pressures are undeniable and likely only beginning, it is far from clear that raising rates by 25bps would do much beyond further damaging already-constrained interest-sensitive sectors while doing little to curb the AI-led investment surge.

In the details

The policy statement continued to describe activity as expanding at a “solid pace” despite Middle East uncertainty, unemployment as having “changed little” and job growth as broadly keeping pace with workforce growth. It acknowledged resilient productivity growth and capital investment while continuing to describe inflation as “elevated” and reflecting supply shocks that have driven price increases in selected sectors, including energy.

The paradox of Chair Warsh’s first “eight weeks and four days” on the job is becoming increasingly apparent. Before taking office, he was a forceful critic of the central bank’s failure to control inflation. Now, with inflation still above target and the committee turning more hawkish, his own instinct appears dovish. He is seemingly asking for patience because the “new” FOMC has only been in place for a few weeks and there is no magic wand.

Warsh stressed that “five-plus years of inflation above target cannot be cured in nine weeks or a month of modest price decreases.” Yet when asked why the Fed should not simply raise rates to address persistent inflation, he responded rhetorically: Is that the dominant tool? Is that the best strategy?

He noted that his own judgment was that “this is a period of watchful thinking, not watchful waiting,” standing in stark contrast with Governor Christopher Waller’s earlier remark that “sternly staring at inflation until it melts before our withering gaze is not an option.”

Reading between the lines, Warsh does not appear eager to raise rates. His opening remarks emphasized the tightening already delivered by financial markets and the potential for strong AI-related capital investment to lift productivity. He suggested that a higher fed funds rate could eventually be part of the solution if inflation remains elevated, but not necessarily in isolation.

Warsh also appeared unusually comfortable relinquishing part of the Fed’s reaction function to financial markets. “Monetary policy matters by how it affects the real economy, and these prices that we see in financial markets are one of the many ways,” he said. Market prices were certainly not saying “all clear” but were “working in concert to keep us on our toes” and had tightened financial conditions, providing some comfort that the Fed retains the ability and capability to deliver.

His suggestion that the rise in yields was unrelated to the recent chorus of Fed speeches was less convincing. In the absence of clear communication from the Chair, investors have been pricing the policy outlook through the individual reaction functions articulated by other Fed officials.

The vote itself offered a clearer signal than the press conference. The 9–3 decision is close to the 35% probability of a rate hike reflected in pre-FOMC market pricing, pointing to a committee that is much closer to tightening than the Chair’s remarks might suggest.

Warsh acknowledged that the discussion was far more robust than the final vote conveyed. “As a choice between two alternatives, you heard the results of it,” he said. “But I would tell you that this discussion was far more robust, and our thinking about how best to achieve that target is advanced.”

The committee’s deliberations centered on four questions: whether the inflation experience of the past five years continues to shape the current policy environment — “Has the past really passed?” — how supply shocks affect output and inflation, whether those shocks will produce more persistent inflation, and what role the balance sheet can play alongside interest rates. In that regard, he seemed to indicate a preference for the balance sheet playing a more active role as a policy tool.

Warsh’s description of his reaction function was a platitude: less a reaction function than a description of central banking. A central banker is more inclined to tighten when underlying inflation is rising and more inclined to loosen once the employment side of the mandate has been achieved and inflation is falling.

The broader message is that the Chair appears willing, at least for now, to relinquish part of the policy signal to financial markets and part of the decision to the committee. His repeated references to enjoying a “good family fight” reinforce the impression that he intends to emphasize collective decision-making rather than his own preferences.

That may allow Warsh to avoid pre-committing to a policy stance and preserve some distance from any future tightening. But the signal from the press conference was nevertheless dovish, and it may not endure. Warsh may be hiding behind the committee and markets, but the committee itself is turning more hawkish. Unless inflation resumes a convincing downward trajectory, its judgment could soon overtake his own.