A Fed Hike Could Break the Market’s Fedamentalism

Recently, Federal Reserve Chairman Kevin Warsh spoke at the International Monetary Fund’s annual meeting in Bangkok, clearly stating that he wouldn’t disclose the Fed’s plans regarding interest rates.

“I don’t prejudge meetings. I don’t believe in saying now what I might do at the meetings we have in the balance of this year,” Warsh remarked. “It’s a new chapter at the Fed, and we’re not in that business anymore.”

Wall Street’s immediate reaction was to bolster its own expectations regarding the Fed’s actions. Before Warsh’s remarks, fed funds futures indicated a 72 percent likelihood that rates would be held steady at the upcoming October meeting. Following his statements, that probability soared past 85 percent, and by Thursday evening, it was an unprecedented 95 percent, reflecting an almost absolute certainty just days ahead of the meeting.

In essence, Warsh informed investors that he was not providing forward guidance, and yet investors interpreted this as a signal that rates would stay unchanged.

This is quite a feat. It seems Wall Street has become so accustomed to receiving direction from the Fed that now, even a lack of communication is seen as confirmation of existing predictions.

The Economic Case for an October Hike

Investors face a dilemma: the economic data increasingly suggests that another interest rate hike is justified.

The Fed had raised its benchmark rate by a quarter percentage point in September, setting the target range at 3.75 to 4.00 percent. Many Fed officials expected another hike would be needed before year’s end.

Since that time, the inflation situation has worsened significantly.

The consumer price index increased by 0.6 percent in September, marking a 3.7 percent rise year-over-year. Producer prices surged 1.3 percent for the month and 6.3 percent annually. More concerning, inflation is spreading beyond just energy costs. Core consumer prices rose by 0.3 percent, and producer prices, excluding food and energy, went up by 0.7 percent.

Moreover, the economy doesn’t seem to be faltering despite higher interest rates. Consumer spending remains strong, business investments are thriving, and U.S. factories are ramping up production, particularly in machinery, electrical equipment, and semiconductors. The Conference Board’s Leading Indicators, released Thursday, indicate economic strengthening, not weakening. Jobless claims also dropped to 194,000 last week, maintaining the lowest three-month average since 1969.

It’s reasonable to argue that the Fed’s current policy rate might not be overly restrictive given the economy’s strength. If the natural rate of interest has risen due to increased productivity and investment demand, the Fed may need to maintain elevated rates to keep inflation in check.

With inflation on the rise, one might wonder why the Fed should wait until December for another rate increase.

The Fed’s Forward Guidance Trap

However, there is a valid reason for hesitation. Financial markets are so sure that the Fed will keep rates steady in October that a rate hike would be quite unexpected. Additionally, the meeting occurs just six days before the midterm elections, raising the political stakes for any sudden adjustments.

In the previous regimes of Bernanke, Yellen, and Powell, such considerations would have had significant weight. Fed officials dedicated years to ensuring that markets were rarely caught off guard by policy decisions. If markets misunderstood the Fed’s intentions, policymakers would typically aim to correct expectations leading up to the meeting. So if it seemed like the market was anticipating a hike or a pause, it was almost a given that the Fed would align with those expectations.

Warsh, on the other hand, has explicitly dismissed that approach. He wants the Fed to react to evolving economic conditions rather than attempt to manage market expectations about future decisions. He prefers that focus be placed on underlying inflation data and labor market strength. He aims for fundamentals—rather than fedamentals—to take center stage.

Still, declaring an end to forward guidance may not be enough to dispel fedamentalism.

Investors have formed a deep-seated habit of deciphering every speech and comment as a hint toward future policy. They examine Fed statements as if they’re uncovering hidden truths. When Warsh doesn’t play the usual game, his silence becomes another piece of evidence in their analysis. Forward guidance has become somewhat of a specter that lingers over the bond market.

Kevin Warsh: The Exorcist

A rate hike in October could serve as an exceptionally effective exorcism.

It would signal that the Fed is ready to respond decisively to rising inflation. This, in turn, might even lead to lower long-term Treasury yields if investors gain confidence in the Fed’s inflation control. Such reductions would be a relief for the struggling housing market and for businesses eager to invest in the significant AI boom.

However, Warsh shouldn’t raise rates just to catch Wall Street off guard or to provoke reactions from bond traders. While that might be tempting, the economic rationale for an increase must truly justify the decision. That said, if Warsh determines that another hike is necessary, he likely won’t be deterred by the market’s belief that rates will hold steady.

Wall Street is confident the Fed won’t raise rates next week, but Warsh has been indicating otherwise. The market seems overly self-assured, thinking it can still engage in “watch the Fed” instead of “watch the economy.” Perhaps Warsh wants to disrupt that narrative.