Inflation, rates and the Fed's credibility

Kevin Warsh arrives at Jackson Hole with markets looking for something more useful than another hint about the next rate decision. Investors want to understand how the new Federal Reserve chair intends to think. Warsh has moved away from the forward guidance that markets became accustomed to under previous Fed leadership, arguing that investors should pay greater attention to market signals. The result has been greater uncertainty over the Fed's reaction function.

That makes inflation the obvious starting point. The Fed's preferred measure has remained above its 2% objective for more than five years, and economists expect core PCE inflation to have run at about 3.3% year on year in July. Policymakers are also trying to judge how persistent the latest pressures from tariffs, energy costs and the AI investment boom will prove. July's FOMC minutes showed that inflation risks were still seen as tilted to the upside, even though most officials expected price pressures to ease later in the year.

Markets therefore want Warsh to define the Fed's tolerance for an inflation overshoot. Does he believe inflation needs to be brought back towards 2% quickly, or is he comfortable allowing a longer adjustment? And if progress stalls, is he prepared to raise rates again? Futures markets currently put the probability of a September rate increase at about 40%, up from 33% a week ago.

Why the bond market matters almost as much as the Fed

The second issue is the bond market. Warsh has suggested that higher long-term Treasury yields may already be doing some of the Fed's tightening work by raising borrowing costs across the economy. There is logic to that view, but investors want to know how far he will take it. Long-term yields have not risen solely because growth or inflation expectations have strengthened. Concerns about government debt, Treasury supply and a higher term premium have also played a role.

Relying too heavily on those yields to restrain the economy could leave monetary policy looking passive if inflation proves stubborn. Treasury's decision to increase buybacks of longer-dated bonds after the recent sell-off has sharpened the focus on the relationship between Fed policy and Treasury debt management. Markets want reassurance that monetary policy remains anchored to the Fed's mandate, rather than being influenced by financing pressures or politics.

Warsh must also balance that inflation problem against a softer labour market. US nonfarm payrolls fell by 23,000 in July, while the unemployment rate was little changed at 4.1%. A hawkish surprise at Jackson Hole would likely push short-term yields higher; greater emphasis on weaker growth or labour-market risks could pull real yields and the dollar lower.

But the bigger risk may be ambiguity. Investors can adjust to higher or lower rates. What is harder to price is a central bank whose reaction function they do not understand. Jackson Hole is therefore less about whether Warsh signals a September hike than whether markets leave Wyoming believing they understand the Fed again.