New Fed Chair Warsh is doomed to break with his campaign pitch

Federal Reserve Chair Kevin Warsh heads into his first full week on the job facing an impossible situation. His campaign for the position strongly alluded to the possibility of lower interest rates, something President Donald Trump had been openly demanding of Fed leadership. He also committed to reforming Fed communications to give a lot less "forward guidance," a tool that has made the Fed less nimble in his reckoning. Warsh will have to backtrack on at least one of those stances as fixed-income markets drift in a decidedly hawkish direction.

Futures trading on Friday implied expectations for a Fed interest rate hike in December. Rate cuts might have seemed plausible a few months ago when the Fed beauty contest was underway, but the U.S.-Israeli conflict with Iran has triggered an enduring surge in energy prices, leaving inflation running well above the Fed’s 2% target. (It will probably move higher still when May data is published.)

This energy shock comes after a half-decade of above-target inflation, making it harder for central bankers to "look through" it as a temporary move that won’t destabilize inflation expectations. It also lands in the middle of an artificial intelligence boom that’s lit a fire under the stock market and parts of the economy.

Bond markets are telling us that this economic mix will make it hard for the Fed to keep rates steady — and extremely hard for it to make a coherent case for cuts. The sharp rise in benchmark bond yields and mortgage rates over the past three months may reduce Warsh’s options to implicitly blessing the market’s hawkish outlook or trying to talk bond yields back down in a betrayal of his minimal-forward-guidance pledge.

Further complicating matters is Warsh’s relationship with Trump, the man who put him in the job he’s coveted since he was at the Fed during the financial crisis. Trump paid lip service to the idea of Fed independence during Warsh’s swearing in on Friday. No sooner had he finished, though, than he launched into a riff about how the economy was doing well and the Fed should "just let it boom." And by the way, he added, "we do have some debt we’d like to take care of, and the way you do that is through growth."

Trump has called for rates of 1% or lower since he was reelected, and it doesn’t sound like he’s abandoning his ultra-dovish impulses.

As for Warsh’s promise to reform Fed communications, it was always going to be tricky.

The Fed chair holds post-decision news conferences following a decades-long move toward greater central bank transparency; the members of the rate-setting committee speak at length during the intermeeting periods; and they publish their economic and policy expectations — the so-called dot plot — four times a year for all the world to see. Such "forward guidance" has allowed the Fed to steer bond markets, including at longer maturities, long before the central bank officially adjusts rates. There’s also some inherent value in simply keeping the American people abreast of developments in their thinking: It makes the Fed feel less shadowy.

Warsh believes it also locks them into their forecasts.

"The Fed tells the whole world what their dots are going to be, what their forecasts are going to be," Warsh said at a hearing before the Senate Banking, Housing and Urban Affairs Committee during his confirmation hearing. "Well, the Fed’s human. Then they hold onto those forecasts longer than they should. I think if the Fed were to wait until it gets into a meeting before making a decision, that incremental deliberation can keep the central bank from compounding its errors. I think these are big changes that are needed."

A vow of silence isn’t going to get Warsh out of the pickle he’s in today. There’s an implicit tightening afoot in the Treasury and housing markets, and Warsh can’t stop it unless he starts talking. He’ll need to make a compelling case for why the market has it wrong — and he’ll have to convince the 11 other voters on the Federal Open Market Committee. He’ll need to show that, while stocks and AI capital expenditures are booming, the labor market is weak. He’ll also need to make the much more speculative case that the sort of growth that’s coming from the AI revolution isn’t inflationary (as I’ve argued, this is a particularly dubious thesis at the moment.)

Minutes from the Fed’s most recent meeting showed a majority of officials thought they would need to consider raising interest rates if inflation continues to run persistently above their 2% target. Fed Governor Christopher Waller, an influential bellwether on the committee who was in the running for Fed chair himself, said Friday that a hike is as likely as a cut when the Fed moves next.

That means Warsh is probably going to end up breaking one of his campaign promises — maybe as soon as his first meeting on the job. An early bit of hypocrisy may be inevitable with an unruly bond market and a demanding president to manage.

This column reflects the personal views of the author and does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Jonathan Levin is a columnist focused on U.S. markets and economics. Previously, he worked as a Bloomberg journalist in the U.S., Brazil and Mexico. He is a CFA charterholder.