Summary
Highlights
Kevin Warsh, handpicked by Trump to cut interest rates, has declared zero tolerance for inflation in his recent Capitol Hill testimony. He emphasized the Fed's independence and commitment to fighting persistently high inflation, stating, "The inflation surge of the last five years will be a thing of the past."
June CPI came in at -0.4% on the month, bringing the annual rate down to 3.5% from 4.2% in May, beating expectations. This led markets to believe rates would hold steady, and potentially see cuts by year-end. However, this interpretation is seen as partly dangerous, as the decline was primarily driven by energy prices.
Stripping out food and energy, core inflation was flat at 2.6% annually, with the energy index still up 15.7% year-over-year. Warsh's statement, "Inflation is a choice," made under oath, signals a public commitment to tackling inflation. This is not the language of someone planning political favors, but of an activist on a mission. Nearly half of the Fed committee has penciled in rate hikes before year-end, indicating a "higher for longer" approach.
The current inflation is largely supply-driven, stemming from events like the Strait of Hormuz crisis. Raising interest rates cannot produce more oil or fix geopolitical choke points; in fact, higher rates might amplify cost pressures by increasing borrowing costs for energy supply chains. Warsh, with his extensive background, understands this limitation.
Warsh's firm stance, despite the limitations of monetary policy against supply shocks, is crucial for maintaining the Fed's credibility. If the Fed blinks, the bond market will react negatively. He is following the playbook of Paul Volcker, prioritizing credibility as an asset. When asked about presidential pressure, Warsh vowed to "follow the law and follow the data," underscoring his independence.
The era of the 'Fed put' is over; the Fed will no longer prioritize market comfort over its credibility. Investors should not expect bailouts for bad trades. The "higher for longer" scenario extends beyond mortgages, impacting leveraged deals, commercial real estate, and regional bank balance sheets. The slow-motion reckoning in credit markets will continue.
The Fed is moving away from forward guidance, focusing on data rather than market signaling tools like dot plots or 'Fed speak.' This transition will be unsettling for investors accustomed to explicit market management. The best approach is to understand Warsh's game plan, which centers on fighting for the Fed's credibility, making its reputation the collateral. The bond market will react first, with individual portfolios feeling the effects later.