The Federal Reserve will likely leave interest rates unchanged at its policy meeting on Wednesday. Investors should listen closely nonetheless.
Inflation has accelerated since the Fed raised rates in September, strengthening the case for another rate hike before year end. Weakening the case: Financial markets have begun responding to the prospect of tighter policy, pushing borrowing costs higher and pressuring parts of the economy that were already struggling, like the housing market.
That leaves Fed Chair Kevin Warsh with plenty to explain when he faces reporters Wednesday afternoon. The most pressing question he will be asked is how much more work the Fed thinks it needs to do to bring inflation under control.
The consumer price index rose 3.7% in September from a year earlier, up from a 3.4% rise in August. Producer prices jumped 1.3% for the month, and businesses are going to pass along at some of these higher costs to customers.
Crude oil prices have also remained elevated, adding to inflation pressures as they lift transportation and production costs in the months ahead.
Those developments have caused economists to reconsider how quickly inflation will return to the Fed's 2% target.
Fed officials' forecasts are too optimistic, says Neil Dutta at Renaissance Macro Research. Higher energy costs, persistent housing inflation, and supply-chain disruptions could keep price pressures elevated well into next year.
The Fed raised its benchmark rate by a quarter percentage point for the first time since 2023 in September, to a range of 3.75% to 4%. Another increase could come as soon as December, although officials have indicated they may want more time to assess the economy.
So, what will Warsh say he makes of recent moves in the bond market?
Treasury yields climbed following September's rate increase as investors prepared for additional tightening. The benchmark 10-year yield rose above 5.3% in October, its highest level in more than two decades. Mortgage rates have remained above 7%, the weak housing market is hurting home builders, and borrowing has become more expensive for riskier companies.
Treasury yields have since dropped, but borrowing costs remain elevated.
Financial markets can tighten lending without the Fed changing its benchmark rate. Higher borrowing costs discourage businesses from investing and households from spending, slowing demand and eventually arresting inflation.
It is difficult to quantify how much restraint markets are actually delivering.
The effects are uneven: Technology companies continue to spend heavily on artificial-intelligence infrastructure, while housing construction has fallen to levels seen during recessions.
Claudia Sahm, chief economist at New Century Advisors and a former Federal Reserve economist, argues that the Fed shouldn't rely too heavily on financial markets to restrain the economy. The recent volatility in Treasury yields shows how quickly financial conditions can change, she says. "Only the Fed can do its job," Sahm writes.
Warsh's assessment of those conditions could give investors a clue to how much more tightening the Fed believes is necessary.
Several Fed officials have suggested that there is little urgency to raise rates immediately, and Warsh said this month that economic developments since September matched the central bank's expectations, which also suggests a pause.
But the string of hot inflation reports could make waiting to raise rates hard to justify.
Sahm argues that waiting carries risks of its own. A modest rate increase now could provide insurance against inflation remaining persistently elevated, while reducing the possibility that the Fed will have to raise rates more aggressively later. "A rate hike is not urgent, but it is prudent," she wrote.
The Fed's October meeting will give Warsh an opportunity to explain how he is balancing those risks, and what would persuade him and his colleagues to act again.
The October Fed meeting also comes less than a week before the midterm elections. Historically, elections have had little bearing on the Fed's interest-rate decisions, although the timing of Wednesday's meeting will invite political scrutiny.
For investors, the question Wednesday is whether the Fed believes financial markets have done enough tightening to buy it more time, or whether Warsh and his colleagues will have to finish the job themselves in December and beyond.
Comments