The Ineffectual Fed Hike

US Federal Reserve (Fed) Chair Kevin Warsh and the Federal Open Market Committee voted 12 – 0 to raise the fed-funds target range by 0.25 percentage point (ppt) on Wednesday, lifting the range to 3.75% to 4.00%.^[i]

In doing so, Warsh made good on commentary from the annual monetary policymaker retreat at Jackson Hole, Wyoming and other affirmations of his commitment to a 2% y/y inflation target.^[ii] And, in doing so, he also rebuked his own comments from the run-up to his appointment about the economy being able to handle lower interest rates as rising, market-set long rates tighten monetary conditions for the Fed.^[iii] And, finally, in doing so, we think the Fed has made a minor mistake. The key, in our view, will be for it to learn that before hikes go too far.

First, our reviews of market history show there is nothing automatically negative about rate hikes. Yes, yes, we know: The S&P 500 fell after the move was unveiled, flipping a small rise to a small dip on the day (-0.45%).^[iv] But history is filled with examples of hike cycles coinciding with rising markets, including this one’s birth in October 2022 through the first rate cut in September 2024. In that span, US stocks boomed 62%.^[v] Other examples include hikes from 2015 to 2019.^[vi] And those in the mid-2000s.^[vii] And at points in the 1990s.^[viii] We could go on.

Now, it is true hikes were one of a cornucopia of negatives contributing to the shallow, sentiment-driven bear market that ended in October 2022.^[ix] But key to those hikes’ power? Surprise. Before they hiked, central bankers worldwide had long said they would look through “transitory” higher inflation rates.^[x] When they finally began conceding hikes were needed, they promised a “gradual” path.[xi] The resulting fast pace, including 0.75 ppt moves the Fed said previously said weren’t coming, was a surprise.^[xii]

Wednesday’s move wasn’t a surprise. Not only did Warsh make comments construed as anti-inflationary at Jackson Hole in August, but markets had pre-priced a 90% likelihood of a hike before yesterday’s meeting.^[xiii] This was the central expectation, according to our review of financial media: Most commentators thought it was coming. Beyond this, we have already seen other monetary policymakers in Europe and Australia hike multiple times and, whilst Warsh took pains to suggest every monetary policy institution operates independently on its own remit, historical evidence suggests groupthink abounds amongst policymaking boards.^[xiv]

On its own, we think this hike achieves little for good or ill. Our research shows the chief way hikes influence the economy and markets is by influencing the yield curve’s shape. The yield curve is a graphical representation of one bond issuer’s rates, arrayed from short-term to long-term maturities. We find banks typically borrow short term to fund long-term loans. So when long rates top short, new lending is generally profitable. One 0.25 ppt hike doesn’t materially change that, as US 10-year Treasury yields still top 3-month by almost 0.90 percentage point after the hike.^[xv] Even if the Fed hikes once more as some officials project, there would be one more hike by yearend.^[xvi] That scope of action is unlikely to change much from a yield curve perspective, in our view.

We also suspect it isn’t likely to change much about inflation trends, contrary to Fed insistence. We get the Fed’s argument: The Fed’s targeted inflation measure, the headline personal consumption expenditures (PCE) price index, is above the 2% target and accelerated to 3.7% y/y in July.^[xvii] But this acceleration centres on energy, which we think the Fed is largely powerless over.

We saw one reporter sensibly ask Warsh at the press conference we watched what he thought a hike could do to energy prices, given they cannot reopen the Strait of Hormuz. He answered with generalities about oil’s rise spilling elsewhere in prices economywide. Ok, but Warsh also insisted in the same press conference trends in data matter more than anything. In the 118 days since Warsh took office, what inflation trend suggests there are rising price pressures outside oil? It doesn’t seem to us to be the consumer price index excluding energy, considering it rose 2.5% y/y in August, below the 2.6% rate when he was nominated in March … and the 2.9% when he was confirmed in May.^[xviii] The trend here is slight cooling. Core PCE (ex. food and fuel) similarly sits at 3.3% y/y, barely above January’s 3.1% and down from May’s highs.^[xix]

All those rates are above the Fed’s target. But that has been the case for years, even when Warsh was saying lower short rates could be appropriate and held them in July.^[xx] What changed?

So we see this hike as quite ineffectual—for good or ill. Now, we see some commentators viewing every Fed action in terms of cycles, presuming more hikes are assured to come later. History disagrees: Cycles are historical reflections of a series of decisions. The Fed and other central banks have made one-off hikes before, too. In March 1997 they hiked 0.25 ppt—with their next move a cut and no other hike until 1999.^[xxi] In December 2015, the Fed hiked once … then waited a year to do it again.^[xxii] Is that a cycle? Because that is an awfully long pause if so. In May 1983, they did the same … and moves with long pauses around them aren’t uncommon in the 1970s and earlier 1980s.^[xxiii]

For whatever it is worth, at the press conference, Warsh dismissed any suggestion one hike means more will assuredly follow. That is good to hear, in our view, but the Fed would benefit from wising up to its error here before it hikes too far.