(Bloomberg) — Federal Reserve Chairman Kevin Warsh is creating fresh uncertainty for investors by pledging to rein in inflation without explaining how he intends to do so, according to Citadel Securities.
While Warsh has repeatedly said the central bank needs to tame consumer-price increases that have exceeded its target for five straight years, the Fed again left interest rates unchanged last week even as three policymakers favored an immediate increase.
Instead, Warsh argued that the recent rise in Treasury yields had already tightened financial conditions, allowing markets to do some of the Fed’s work. He also suggested that the central bank could rethink whether its preferred inflation gauge should remain the current benchmark after its policy framework review.
Investors responded by selling long-term Treasuries, pushing up inflation expectations and sending the dollar and stocks down. The moves underscored “a challenge to the credibility or clarity of the policy framework,” Nohshad Shah, Citadel’s head of EMEA fixed-income sales, wrote in a note.
Shah’s colleague — head of macro strategy Frank Flight — last week argued the Fed should surprise markets with a rate increase, given that an overwhelming majority of economists expected policymakers to stand pat. He said such a move would have reinforced Warsh’s inflation-fighting credibility and helped anchor expectations.
In the note, Shah said relying on markets to tighten financial conditions risks creating a negative feedback loop. Higher long-term borrowing costs encourage the Fed to wait longer before raising rates, which in turn would likely prompt investors to demand even larger inflation and term premiums, pushing yields higher still.
“The Fed holds because markets have tightened, while markets tighten because the Fed has held,” he wrote.
Shah argued that not all increases in yields tighten financial conditions in the same way. While higher short-term rates driven by expectations of Fed tightening help restrain demand, a rise in long-term borrowing costs fueled by investors demanding greater compensation for inflation and policy uncertainty could instead erode confidence in the central bank’s commitment to price stability, he wrote.
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