Beyond the hike: Why Fed credibility and disinflation matter now

Warsh came into this position talking real tough on inflation, saying all the right things, but really not following through with any action. And so, at the September Federal Open Market Committee (FOMC), he backed up those words with action with a 25 basis point increase in the Fed funds rate. That action alone is important. But also, other factors about this meeting were important as well, one key factor being the unanimity of the decision-- the universal vote to increase interest rates without any dissent. 

And then also, the cohesiveness that was there within the summary of economic projections, with all Fed members essentially in line with not only this interest rate hike, but projecting forward, at least another interest rate hike. So that really did strengthen the credibility of this move to really lock down inflation risks and inflation expectations.

If you have a view — which we do — that inflation is likely to start easing as soon as the end of September when we get the newer PCE data with the methodological adjustments, and then on a shorter term to medium term basis, is some of the inflationary pressures that are really elevating inflation year to date dissipate — namely, tariff pressures, which have been non-existent in recent months but are still in the 12 month window. So we have upward pressure from tariffs that are going to roll off and the upward pressure from energy as a result of the conflict in Iran. 

Now, energy prices remain elevated, but as long as they don't elevate further, that inflationary impulse should fade as well. So those waves of inflation fading out of the picture should allow disinflation to take hold. And we believe that and the Fed believes that. When they projected forward inflation about a year to the end of next year, they see core PCE at 2.5%. So really, not a need to hike rates significantly further from here. 

I think that is also comforting to the marketplace, and part of the reason why risk assets are taking this in stride and long end Treasury yields as well. We're discounting now in the marketplace — two to three more interest rate hikes from here, from September. And if we really drill into what the complete Fed package was, it seems the Fed's indicating maybe one to two more in their most modal base case view. 

So really, just a little bit more of an adjustment upward in rates. And that ought to be enough to get us to this place where inflation just starts organically rolling off, easing towards 2%. Now, it's going to take some time. We're not overly optimistic on inflation, but we do expect the year-on-year rate to start ticking down and to be into the mid-2's by the middle of next year with a solid underlying trend.

So there is some opportunity on the yield curve now. We think it's a good time to take incremental duration risk, move out the curve. So we do see opportunities in the long end of the curve at these yield levels. 

And also, volatility in financial markets we think should be somewhat subdued from here, given that the Fed has now provided us with a bit of a roadmap — not forward guidance, but how they're thinking about inflation now. And we know the likely response, given that they've signaled at least another rate hike and maybe two more, but not much more than that. There isn't a single member of the Fed right now projecting more than two interest rate hikes from here. 

Asset class that should benefit from this would be agency mortgage backed securities, if implied market volatility is going to remain subdued. There's good yield on those instruments now, so that's a new opportunity that's becoming a little more attractive as a result of the September FOMC. And again, long end of the yield curve is starting to look more attractive on an outright basis.

But really, it's that subdued volatility and the reduced inflation risk premium that should buoy long duration assets and carry assets, and assets exposed to volatility.