Newly appointed Federal Reserve Chair Kevin Warsh made a definitive statement at the July FOMC press conference, showcasing a tough anti-inflation stance. He emphasized that there is no soft inflation target or unspoken hidden goal, a clear reference to market suspicions that the Fed publicly insists on 2% but is actually more lenient with inflation overshoots. This direct declaration could strike at the heart of the current overvalued U.S. stock market, signaling that the Fed will not turn a blind eye to high inflation.
For the past four years, bullish sentiment has dominated Wall Street. Fueled by the artificial intelligence wave and strong corporate earnings, the Dow Jones, S&P 500, and Nasdaq have repeatedly hit new closing highs since early June. However, the biggest uncertainty for the overvalued market is inflation, and Warsh's policy shift since taking office has amplified this risk. The first clear appearance of his hawkish stance came during the FOMC press conference on July 28-29, where he noted that high inflation over the past five years has led some households, businesses, and market participants to mistakenly believe the Fed's implicit target is higher than 2%. He made it clear that under the current committee's term, there is no soft inflation target, meaning they are not waiting for inflation to fall back to the 2% long-term goal on its own but are prepared to take more proactive action.
The potential impact on the overvalued stock market is significant. Currently, the U.S. market is at its second-highest valuation level in history, heavily reliant on AI infrastructure construction to maintain high-growth expectations. If the Fed shifts to a more hawkish policy and pushes interest rates higher, rising borrowing costs could slow data center construction, leading to a rapid downward revision of AI-related stock valuations. The AI-driven bull market could face notable correction pressure as a result.
The so-called "Trumpflation" is evolving into a broader issue. The real challenge Warsh faces is that the nature of U.S. inflation pressure is changing. While the overall inflation rate fell from a three-year high of 4.2% in May to 3.5% in June, the outlook is worsening. The initial shock came from the Iran war, which after President Trump's February 28 decision to strike Iran, led to the closure of the Strait of Hormuz, disrupting the transport of about 20 million barrels of oil liquids daily and driving up fuel prices. This almost single-handedly pushed U.S. inflation from 2.4% in February to 4.2% in May. Now, the war's impact has spread to broader areas, with businesses forced to change shipping routes, switch suppliers, or pay higher costs for petroleum-based products like plastics, which are ultimately passed on to consumers. Additionally, the Trump administration's new round of tariffs on over 80 countries last month broke the FOMC's earlier expectation that tariff effects would be mostly absorbed by year-end. Taxing imported intermediate goods raises U.S. production costs, and businesses often pass these higher costs on to consumers. The stickiness of core personal consumption expenditure prices already shows inflation spreading to broader economic sectors. Furthermore, AI itself has been named by Fed officials as a new source of inflation, with strong demand for AI chips and storage supporting stock index gains, but the powerful pricing power of related companies ultimately translates into higher prices for consumers. The inflation pressure from the current imbalance in AI hardware supply and demand has no simple short-term solution.
The risk of rate hikes is rising. With long-term Treasury yields continuing to climb and the Fed chair clearly stating a firm commitment to curb inflation, the likelihood of the Fed taking more aggressive tightening actions is increasing. For the overvalued U.S. stock market, heavily dependent on low interest rates and the AI narrative, this could become the most significant risk to watch moving forward.
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