In short
Whether the Fed can “hold the line” on inflation and employment, given high inflation, limited policy options, and market expectations.
Guest backgrounds
No guests are named; the episode is hosted by Andrew Sheets (Morgan Stanley Fixed Income Research).
Key claims
Unemployment is near historical lows, but U.S. prices have risen over 20% in five years versus a 2% annual goal; PCE inflation is above 3% annualized over 3/6/12 months; ISM manufacturing price increases are well above normal. Warsh emphasizes lowering inflation and reducing excessive Fed communication that may have encouraged investor risk-taking and constrained policy.
Notable examples
Market reaction to Warsh’s lack of guidance—reduced rate-hike odds, steepened yield curve via long-end sell-off, higher expected inflation, weaker dollar; Waller’s “sternly staring at inflation… is not an option.”
Written by AI. May contain mistakes. Listen to the episode to check what was said.
Chapters
Tap a time to open that second in VOThe Fed's Complex Role
0:10 to 1:11
Exploring the Federal Reserve's dual mandate of employment and price stability.
“The Federal Reserve has a difficult job.”
Challenges of Inflation Control
1:11 to 2:27
Discussion on the high inflation rates and the Fed's response options.
“What markets are now processing is a potential tension between these two goals.”
Market Reactions and Expectations
2:27 to 3:31
How the markets are adjusting in response to the Fed's stance and inflation data.
“The prospects for rate hikes were reduced, the yield curve steepened, led by a sell-off of long-end yields, measures of expected inflation rose, and the U.S.”
Transcript
Automatic transcript. May contain errors.0:00Andrew Sheets:Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley. Today, can the Fed hold the line? It's Wednesday, August 5th at 2 p.m. in London. The Federal Reserve has a difficult job. The U.S. economy is a complex and varied ecosystem that covers everything from brain surgery to your burger order. The Fed is asked to keep prices stable and people employed using, for the most part, just one simple tool, a short-term interest rate, and without any control over what government policy or global events might bring. Currently, the Fed probably feels pretty good about its success with one half of this in the job market, given that the unemployment rate is near historical lows.
0:46Andrew Sheets:But it probably feels less successful about price stability. Over the last five years, overall prices in the U.S. economy have risen over 20 % based on the Fed's preferred inflation measure. That's roughly double the increase that a goal of 2 % annual inflation would otherwise bring. Into this complexity steps a new Fed chair, Kevin Warsh. He has emphasized two changes for his tenure. First, that inflation is too high and needs to come down. And second, that the Fed has historically communicated too much with the market, which Chair Warsh thinks has helped contribute to investors potentially taking too much risk, while also restricting the Fed's options to act.
1:26Andrew Sheets:What markets are now processing is a potential tension between these two goals. After all, high inflation is an immediate issue. In a world where the Fed is hoping to keep price increases at about 2 % per year, their preferred measure, PCE inflation, is rising more than 3 % on an annualized basis over the last 3, 6, and 12 months. In the latest ISM manufacturing survey, measure of price increases among manufacturers is well above normal. In the face of that, one option for the Fed to combat this inflation would have been to raise interest rates. It didn't do that. Another would be to suggest that it was very close to taking action and likely to move soon.
2:07Andrew Sheets:It didn't do that either. Indeed, our economists think that the market took Chair Warsh's lack of guidance and action at the most recent Fed's meeting to suggest a pretty high bar for rate hikes, and even the potential to redefine the Fed's 2 % inflation target in favor of something more general and unspecified. The result was a market reaction that would suggest less focus on inflation. The prospects for rate hikes were reduced, the yield curve steepened, led by a sell-off of long-end yields, measures of expected inflation rose, and the U.S. dollar weakened. In the days since, markets have settled a bit.
2:44Andrew Sheets:But the result is going to be a market that is now going to be much more sensitive to incoming inflation data. If that inflation data moderates in the second half of this year, as we at Morgan Stanley expect, then the Fed's approach could look justified, as the data suggests that neither action nor more communication about what they're going to do is necessary. But if inflation doesn't cooperate, the challenge becomes immediate. Christopher Waller, another member of the Fed, recently said that, quote, sternly staring at inflation until it melts before our withering gaze is not an option. The market will expect action and expect a framework explaining that action.
3:25Andrew Sheets:Until that point, our rate strategists think that yield curves will continue to steep it. Thank you, as always, for your time. If you find Thoughts of the Market useful, let us know by leaving a review wherever you listen, and also tell a friend or colleague about us today.
3:42the preceding content is informational only and based on information available when created it is not an offer or solicitation nor is it tax or legal advice it does not consider your financial circumstances and objectives and may not be suitable for you
From the publisher
From short-term interest rates to long-term bond yields, the Fed's credibility is being tested. Global Head of Fixed Income Research Andrew Sheets discussed inflation, Federal Reserve Chair Kevin Warsh's outlook, and the options ahead.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.
Today: Can the Fed hold the line?
It's Wednesday, August 5th at 2pm in London.
The Federal Reserve has a difficult job.
The U.S. economy is a complex and varied ecosystem that covers everything from brain surgery to your burger order. The Fed is asked to keep prices stable and people employed using, for the most part, just one simple tool. A short-term interest rate, and without any control over what government policy or global events might bring.
Currently, the Fed probably feels pretty good about its success with one half of this – in the job market, given that the unemployment rate is near historical lows. But it probably feels less successful about price stability. Over the last five years, overall prices in the U.S. economy have risen over 20 percent based on the Fed's preferred inflation measure. That's roughly double the increase that a goal of 2 percent annual inflation would otherwise bring.
Into this complexity steps a new Fed chair, Kevin Warsh.
He has emphasized two changes for his tenure. First, that inflation is too high and needs to come down. And second, that the Fed has historically communicated too much with the market, which Chair Warshkeep thinks has helped contribute to investors potentially taking too much risk while also restricting the Fed's options to act.
What markets are now processing is a potential tension between these two goals.
After all, high inflation is an immediate issue. In a world where the Fed is hoping to keep price increases at about 2 percent per year, their preferred measure, PCE inflation, is rising more than 3 percent on an annualized basis over the last three, six, and 12 months. In the latest ISM Manufacturing Survey, [the] measure of price increases among manufacturers is well above normal.
In the face of that, one option for the Fed to combat this inflation would have been to raise interest rates. It didn't do that. Another would be to suggest that it was very close to taking action and likely to move soon. It didn't do that either.
Indeed, our economists think that the market took Chair Warsh's lack of guidance and action at the most recent Fed's meeting to suggest a pretty high bar for rate hikes; and even the potential to redefine the Fed's 2 percent inflation target in favor of something more general and unspecified.
The result was a market reaction that would suggest less focus on inflation. The prospects for rate hikes were reduced, the yield curve steepened, led by a sell-off of long-end yields, measures of expected inflation rose, and the U.S. dollar weakened.
In the days since, markets have settled a bit. But the result is going to be a market that is now going to be much more sensitive to incoming inflation data.
If that inflation data moderates in the second half of this year, as we at Morgan Stanley expect, then the Fed's approach could look justified – as the data suggests that neither action nor more communication about what they're going to do is necessary.
But if inflation doesn't cooperate, the challenge becomes immediate. Christopher Waller, another member of the Fed, recently said that "Sternly staring at inflation until it melts before our withering gaze is not an option."
The market will expect action and expect a framework explaining that action. Until that point, our rate strategists think that yield curves will continue to steepen.
Thank you, as always, for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen, and also tell a friend or colleague about us today.