Instead of making noise by issuing statements that could influence investor expectations, the US central bank seems determined to let the markets interpret the economic data and assess the risks on their own.
Following two days of deliberations, the US Federal Reserve (Fed) kept its policy rate unchanged on Wednesday, while signalling that further monetary tightening remained a possibility if inflation persisted. As markets had anticipated, the Federal Open Market Committee (FOMC) kept rates within a range of 3.5% to 3.75%, marking the fifth consecutive meeting with no change.
During a press briefing, Fed Chairman Kevin Warsh reaffirmed the central bank’s commitment to its inflation target. He emphasized that there was no “soft target” in this regard and that the US central bank remained determined to bring inflation back to its target level.
“For some households, businesses, and professionals, five years of high inflation have left a misleading, hard-to-dispel impression that the Fed’s implicit inflation target is higher than 2%,” Mr. Warsh explained. “I repeat: there is no soft inflation target. There is no implicit target, at least within the scope of this committee’s responsibilities. There is only one target, and it is 2 percent.”
From his very first public remarks as chairman of the Federal Reserve, Kevin Warsh has emphasized the priority placed on restoring price stability. While he reaffirmed the institution’s commitment to bringing inflation back toward its target, he refrained from specifying the tools or approach that will be prioritized to achieve this goal.
Our Observations
The Fed Got It Right Today
We must admit that the Federal Reserve is operating very differently under Warsh than it did under Powell. Rather than providing guidance that influences investor expectations, Warsh appears determined to let markets interpret economic data and price risks independently. His comments and responses during the Q&A reinforced this philosophy. He made it clear that he does not want to interfere with market signals or encourage speculation about future policy decisions. Instead, he emphasized that between now and Jackson Hole, the Fed will rely heavily on the work of its various task forces, expressing confidence in the expertise and quality of the people involved. However, we were left with little additional insight into the specific indicators he and his colleagues are monitoring.
From our perspective, the Fed made the right decision. Research from the San Francisco Fed suggests that the recent reflation in the United States is not being driven by excessive demand. The categories identified as demand-driven have shown disinflation since last August. Instead, inflation pressures are largely tied to supply-side factors and other components that are difficult to classify as either demand or supply related. Similarly, much of the current inflation appears non-cyclical rather than cyclical. Non-cyclical inflation cannot be brought down by a cyclical tool that is an interest rate.
Recent inflation data also support our base case scenario. Core inflation readings have been relatively soft in the United States while remaining stronger in Canada. Entering the third quarter, the starting point is 0.2% for the core CPI in the US and 1.2% in Canada. Although upcoming inflation reports could change these trends, Canada begins from a much stronger inflationary position in the third quarter.
We also note that much of the discrepancy between CPI and PCE services inflation is explained by a single category: financial services. This component accounts for nearly the entire gap because it carries a much larger weight in PCE calculations due to its market-value measurement. Excluding it would likely provide a more accurate picture of underlying US services inflation. We expect the Fed’s data task force to reach a similar conclusion.
More broadly, current economic conditions do not suggest fundamentally inflationary demand pressures. Consumption growth remains modest and below productivity growth, while unit labour costs are running below 1%. Strong supply dynamics are boosting corporate profit margins and supporting equity markets, yet they are not generating excessive consumer spending. Demand and supply growth remain broadly balanced.
We therefore question the rationale for higher policy rates if reflation is primarily supply-driven, especially when inflation outside energy appears set to decline. Importantly, inflation expectations have fallen considerably under Warsh, even amid wartime risks to oil prices. This suggests he has successfully anchored expectations. As a result, we continue to believe the Fed’s decision was appropriate despite market expectations about a possible rate hike. Current inflation may appear elevated, but it is not necessarily a reliable indicator of future inflation when it is driven largely by temporary and non-fundamental factors.