Warsh reaffirmed the Federal Reserve's commitment to driving inflation back down to 2% from the mountains of Wyoming, prompting markets to quickly price in a greater likelihood of interest rate hikes. However, Morgan Stanley's Chief Global Economist, Seth Carpenter, suggests in a recent report that this reaction may be overlooking a critical variable: quantitative tightening.
Carpenter noted that Warsh’s stance on rate hikes was previously unclear in July, when he only mentioned that interest rates "could be part of the solution." At Jackson Hole, however, he clarified his position by calling the policy rate the "primary tool" and stating that other instruments should be used "as little as possible, or not at all."
But this does not imply that quantitative tightening will be shelved.
Warsh's Logic: The Balance Sheet as the Root Cause of Inflation
Prior to becoming Fed Chair, Warsh gave a more direct explanation of his views on the two major policy tools during an interview at the Hoover Institution. According to Carpenter, Warsh firmly believes that the $7 trillion balance sheet is the fundamental reason inflation remains above target. At Jackson Hole, he listed "money" as one of the core principles of monetary policy operations, further stating that if the "money" created by the balance sheet is withdrawn, interest rates could be maintained at lower levels.
The chain of logic is clear: reducing the balance sheet tightens monetary conditions, which lowers inflation and thereby reduces the pressure for rate hikes.
Growing FOMC Divisions Make Rate Hike Pressure a Real Risk
Morgan Stanley's original base case assumed no rate hikes this year, predicated on inflation easing moderately enough for the FOMC to abandon the hiking option. But Carpenter points out that the FOMC decides by vote, and there are currently three dissenting votes in favor of rate increases. If summer inflation data fails to convincingly show that price pressures are cooling, a hike will occur.
"Warsh will not put himself on the losing side of a vote," Carpenter wrote. This implies that even if Warsh personally prefers quantitative tightening over rate hikes, he will go along with the committee's majority if it leans toward raising rates.
Morgan Stanley Forecast: Runoff Could Exceed $1.5 Trillion Next Year
Carpenter stated that he does indeed believe quantitative tightening is on the horizon. A recent Morgan Stanley report ("Global Economics and Fixed Income Strategy: Fed Balance Sheet Reform: More Runoff, Less Tightening") projects that the Fed could initiate a runoff of $1.5 trillion or more next year. Carpenter also conceded that his assessment of how the runoff transmits to the economy and ultimately affects inflation differs significantly from Warsh's. Regardless of the transmission channel, the conclusion for markets remains the same: investors pricing in monetary policy must now account for both the interest rate and the balance sheet as tools, which introduces additional uncertainty and debate.
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