Is the Fed the referee or the best player?

0:00Katie Martin: Listeners, do you love listening to the Unhedged podcast? Why not experience it live this summer? At the FT Weekend Festival, you'll have the chance to put your questions directly to FT journalists and influential voices, including Rob Armstrong, that's me, and Katie Martin, my partner on the podcast. You can challenge our ideas and meet others who share your curiosity about the world. Join us on Saturday, the 5th of September at Kenwood House Gardens in London or online as the FT Weekend Paper comes to life. Register now at ft.com forward slash festival and enjoy 10 % off with the code FT podcast.

0:45Katie Martin: There's more information in the show notes.

0:57This week was billed as the Super Bowl for financial markets with a high stakes, high drama meeting for the US Central Bank, the second under its new leadership of Kevin Walsh. His first post-rate decision press conference went pretty well, all things considered. But how did he fare with that difficult second album? Well, not great. It's not so much what he did, but what he said and the market is testing him pretty hard. Today on the show, does the Federal Reserve need to steady the ship here? And if it does, how? This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin.

1:40I'm Katie Martin, a markets columnist at the FT in London, back from some very lazy days on a beach in Greece. Joining me down the line from New York City is the big man Rob Armstrong off of the Unhedged newsletter. Rob, did you miss me?

1:55Katie Martin: Desperately. It's great to have you back. I'm imagining you with a terrible sunburn and smelling slightly of that weird Greek liqueur.

2:04Rob Armstrong: I am a factor 50 girl, so not so much sunburn for me. But yeah, Greek liqueur in question, I think you're referring to is raki, which is horrible and should not be drunk by humans ever. And I forget this every time I go to Greece. Okay. The Fed. So it was a bit of a weird run up to this meeting because of all of the 104 analysts that Reuters goes out and surveys to say, what do you think the Fed's going to do this week? all of them said we think the Fed's going to be on hold. And indeed, it was on hold, didn't change rates, left them in the region of three and a half to 3.75%. But the market was saying in the run up to this, effectively, we think there's a reasonable chance they might raise rates.

2:49Rob Armstrong: We think this is not quite a coin flip, but we think there's a good chance that they will actually do this. So there's a bit of a sort of disconnect in kind of reading what people were expecting out of the Fed going into this. And then there's a big disconnect coming out of it

3:04Katie Martin: as well. On the going into the meeting side, I think what the market was responding to was that there is a perfectly solid case for raising rates here, which is not contrary to what you might read in the newspaper about the war and oil. It's about non-energy inflation, not getting back to the Fed's 2 % target, being solidly over 3%, trending sideways, and the fact that the new Fed chair at the last meeting said the Fed is not going to take any nonsense from this inflation stuff. So between that comment and the facts on the ground, you can see why, you know, I thought they might raise rates before this meeting.

3:49Katie Martin: I thought, you know, it was a defensible move. It wasn't an obvious move, but it was a defensible move.

3:54Rob Armstrong: But the war in Iran doesn't help either. The fact that this just keeps not going away and you keep getting oil bouncing back up towards$100 a barrel, that doesn't help. I totally buy your argument that it's not all about that, but it is also about that.

4:08Katie Martin: Yeah, I think oil doesn't help in the sense that if energy, you shouldn't hike rates because you have a supply shock in oil. That would be a mistake. It wouldn't help. But persistent oil inflation does have a way of finding its way into inflation in other things. So at some point, you say, wow, the oil price is starting to affect wages. And then, yeah, you do have to worry. It is the Fed's problem and it becomes an issue. I just don't happen to think we've gotten to that point quite yet. We're not quite there yet.

4:44Rob Armstrong: But so the reaction to the press conference that Kevin Walsh did, we'll kind of unpack that in just a little minute. But there was a big jump in long-term US borrowing costs. So 30-year bonds fell in price pretty hard. And suddenly, you've got the 30-year yield up at about 5.2%, the highest in 19 years. You've got the 10-year yield at 4.7. And, you know, it's not so long since we had Scott Besson, the Treasury Secretary, indicating quite strongly that he really wanted this thing to be under four. So 4.7 is a long way from there. The stock market dumped about a trillion dollars or so in value on the day of the press conference.

5:33It did pick up a little bit the next day, but it's the bond market that really matters here.

5:38Rob Armstrong: So Rob, explain to the nice boys and girls why that all happened when on the face of it, this was an aggressively boring rate decision where nothing happened.

5:48Katie Martin: I think you have to frame this in terms of Chair Warsh's attitude towards what in central bankers speak is called forward guidance, which in normal human beings speak is giving people hints about what you are going to do next. And the previous chair, Chair Powell, was fine giving hints, saying either in the statement or the press conference, look, we see this risk as the, whether that be inflation or employment, more important, we're leaning towards a cut, we're leaning towards a rate increase, fine. Wors thinks that stuff is bad for reasons we can discuss later and is not playing that game. Nothing in the statement, nothing in the press conference about which way the committee is leading, what we might do next, et cetera, et cetera.

6:34Katie Martin: So then he has a problem. He has said in a very chest puffed out kind of way, we are going to deliver the 2 % inflation target. Let there be no doubt. And we don't mean 2.1. We mean two. Okay.

6:52Rob Armstrong: Yeah, we're going to bring inflation down. And on paper, that means we are going to raise interest rates.

6:58Katie Martin: Exactly. So he has said these things. He said, inflation is too high. We're going to get it down. And then at this meeting, we've done nothing. An innocent reporter in the back of the room raises her hand and said, so inflation is too high. You're going to bring it down. Why are you doing nothing? And he says, because of his UFO guidance, well, we're really thinking hard about that or some other similar vacuous phrase. And it's like, what gives here? You know, what's going on? And so the market says, maybe this guy's all hat and no cattle, as they say in Texas.

7:38Rob Armstrong: Well, even in his opening remarks, because the way these press conferences work is they read from a sheet and then they take Q &A from journalists. But even in the opening remarks, he was saying that markets have changed substantially since the previous meeting and the bonds are a lot weaker, which means that borrowing costs are a lot higher over that period. And it's been like a really sizable move higher in yield since the previous meeting that was like 40 something days beforehand. And we all know that that means that the market is saying we think you have to raise interest rates. And effectively what Kevin Walsh was saying was, you know, not absolutely directly, but effectively what he was saying was we feel like or I feel like that market move does the job for us.

8:27Rob Armstrong: It means that we don't need to raise interest rates because the market has raised market interest rates for us. And this has really got all the Fed watchers really like scratching their chins and saying, you are like, what are you talking about? Yeah.

8:44Katie Martin: I think the problem with this approach, which, and he has, what he said in the past and what he said in the meeting, you're exactly right. It suggests we would prefer the markets to do it rather than us doing it. The problem with that is it is a very short step from the markets doing it for you to the markets telling you what to do. So if the markets raise rates and then you don't follow the market's lead, you are loosening policy. Was it your intention to loosen policy? In other words, acting is when you're letting markets do it, you're engaged in a dance with markets where not doing something turns into doing something.

9:35Katie Martin: and so you know the and again this raises the the the issue of credibility and confidence of the market in warsh uh is he in control of the story now and uh i think that and you're and and when you see those long-term interest rates rise what that suggests is uh the market saying i'm not sure this guy's in charge of the story the inflation story right now but the weird thing was one of

10:03Rob Armstrong: the many weird things was Walsh was saying, I think it's good, actually, that borrowing costs have jumped so much since the last time we did this press conference, because now that we've taken away forward guidance, now that we've stopped spoon feeding markets, that means that markets are able to respond to real data and real events without us getting in the way. And I felt like he kind of framed that as, you know, previously, the central bank has always been in the way previously we've always been dictating the market and now we're not doing that anymore. And I think, again, what are you talking about?

10:39Rob Armstrong: It's never been a thing that the markets have only ever done what the Fed tells them to do, as far as I'm aware.

10:46Katie Martin: In my view, Warsh's comments about the new relationship between the Fed and the market were completely crazy and bear no relationship whatsoever to reality. He said, in the intermeeting period, market attention centered on real data and real economic developments. Market participants are learning to play the ball, not the referee, and market prices will continue to respond in the direction at magnitude they see fit. Now, this is a very appealing metaphor that he's using here. The idea that the Fed has no place telling the market exactly what to do. it's got it's this outsider this referee and the market should do what markets do and that has a nice free market see feel to it the problem is that the fed is not a referee it's a player and in fact it's a really good player it's messy right and the reason it's a player is because ultimately it is the fed that sets short-term interest rates yeah so anytime any market participant sees some incoming data, whether that be an inflation report, an employment report, whatever, they have to think, what does this mean for short-term interest rates?

12:05Katie Martin: And the people who decide what short-term interest rates are going to be are the people at the Fed. So they can't just ignore the Fed. The Fed's in charge. And if the Fed refuses to talk, it doesn't change the fact that the market has to think about what they're going to do.

12:25Rob Armstrong: Again, the Fed's not a

12:27Katie Martin: referee. Don't use that metaphor. It's wrong.

12:30Rob Armstrong: I think you're right. I think the market doesn't see the referee running towards them in a kind of football analogy. They see Lionel Messi or Diego Maradona running towards them.

12:39Katie Martin: Like, that's different. Yeah, and they don't want goals scored on their heads. And that's how it is.

12:46Rob Armstrong: They see a big playmaker coming their way who they know they can't beat. I'm really talking myself into this analogy. I think it really works. But yeah, I agree with you. They don't see a referee. They see a badass player who they know is going to beat them up if they get it wrong. The problem that he has is a lot of mortgage rates, for example, are set by the longer end of the curve. It's what longer term bonds are doing. And they are getting fried because investors are listening to what Walsh is saying, which is, yes, I can see that inflation is above target. No, I'm not going to raise interest rates to tackle that.

13:24And they're saying, don't get it.

13:26Rob Armstrong: Don't like it. I think there's a risk that inflation gets out of hand here. So that sort of that weakens those long term bonds. So you've got long term interest rates in the market picking up quite hard. But there is also this weird thing where, as we've just been saying, washes of the opinion that you can kind of say to the market and say to the great American public, you know, look into my eyes, look into my eyes, not around the eyes, look into my eyes. I'm telling you the 2 % target is still a real thing and we will do whatever it takes to meet that 2 % target. But I'm not going to do it today and I'm not going to tell you whether I'm going to do it tomorrow because we don't do forward guidance.

14:06Rob Armstrong: Yes. So Toby Nangle, our colleague over on Alphaville, has done a piece on this today. A very nice piece. And one of the people he quotes in it is Tony Yates. Hello, Tony. He's a former advisor at the Bank of England. And he basically says that this idea that you can just tell markets you're going to do something and they're going to believe you and respond accordingly is pretty faulty. So at some point, he says, markets will cotton on that you don't actually plan to do anything. You're just relying on the effects of them thinking you'll do something to cool inflation and expectations won't move next time.

14:41Rob Armstrong: So this is why, like nerds like me and Rob who think about this stuff for a living, this is why we get so hung up on central bank credibility because it's enormously important that when investors hear central bankers say this is something I believe strongly or this is something we're likely to do, it's very important that they believe them first time. Otherwise, you can get horrible market moves that nobody likes.

15:07Katie Martin: There is no question that the credibility is more important than the policy itself, right? Markets believing you is more that you will do what you say you will do is a more powerful thing than actually doing the thing. And this is what I was saying about there being a fine line between letting the markets do the work and having markets tell you what to do. And this is very salient to ordinary people in the following sense, which you touched on, but let's make it explicit. The market doesn't understand or comes to the conclusion that you as the Fed have lost track of the short term story. You're not in control.

15:51Katie Martin: That pushes long term interest rates up because the market now thinks these guys aren't in charge. Inflation could get out of control. I need to be paid more compensation to own long-term bonds if inflation might get out of control. Long-term rates rise. With long-term rates, mortgage prices rise. And now you've pissed off every potential homeowner in America. Right? So this stuff is really vivid. And so far, it is not going well.

16:23Rob Armstrong: So what are the main theories around why Walsh is not raising rates? Because one thing I think is quite striking on the back of the press conference that happened on Wednesday is that there's been a quite a sort of cone of silence, but something close to it where generally speaking, investment banks and investment firms have been quite hesitant to criticise the Federal Reserve over the past few months. but it sort of feels a bit like the gloves are off now. Like if you read a lot of the news coverage in the FT, there's lots of investors and lots of analysts at banks who are saying on the record, we think there's a credibility problem here.

17:05Rob Armstrong: We don't think this is enough. We don't think this is good enough. That I think is quite interesting. There is this kind of groundswell of, yeah, I'm sorry, Mr. Walsh, this is not going to cut it. This just isn't, and we don't understand what you're saying to us here. Why are you not following through on the threat? So what are the main theories for why he's not doing it?

17:25Katie Martin: The most basic theory would be he and the rest of the committee have looked at the economy and decided that the persistent inflation, a percentage point or so above the Fed's target, will resolve itself given a little bit of time. You know, the oil stuff will pass through. The last of the tariff stuff will pass through. Maybe they're looking at the fact that wage growth is slowing month after month after month. And this is a perfectly respectable thing to think. We don't need to change policy because the inflation problem is getting better. And that might be something that you could say to markets unless you have sworn off giving forward guidance, in which case you have to be quiet about it.

18:19Katie Martin: Right? Because you've painted yourself into a corner.

18:22Rob Armstrong: Worth noting as well that this was a 9-3 decision. So on the committee that decides on the interest rates, nine of them wanted to keep interest rates on hold. Three of them wanted to raise them. So there is an unusually large level of dissent within the committee. You don't normally get three or more members of the committee saying, I don't believe you and I'm going to vote the other way. It's not impossible that we might get to a situation in the next few months where Walsh is outvoted.

18:48Katie Martin: Yeah, I think that would not be a historical first, but it's been a long time since the chair was in the minority on the committee. But it could happen. But I don't know. I don't have a good sense of how hawkish or dovish Warsh is. Do you? I really don't know. You know, so it's still a bit of a blank slate, isn't it? Yeah, in that sense.

19:10Rob Armstrong: so theory one is this too shall pass the you know inflation will come down just by magic and then the federal reserve doesn't need to do anything after all theory number two though okay a lot of people are saying is look we're left with little option but to conclude that he just doesn't want to raise rates because donald trump doesn't want higher interest rates he has allowed that interpretation to be plausible, even if it's not directly true that Trump is calling him up and saying, you better not raise interest rates, slamming the phone down. You know, that doesn't have to happen. You just need to allow it to be a serious doubt in people's minds, whether there is political interference in mantra policy.

19:56Rob Armstrong: That's not great, I'm going to say.

20:00Katie Martin: Yeah, I think you've framed that perfectly, Katie, because I think that Warsh has no reason to be afraid of Trump. He's got the job now. When Trump tried to make Powell's life hell, it basically didn't work and blew up in Trump's face. I believe Warsh is very free to set the monetary policy he thinks is appropriate. But you've nailed it by saying that the no forward guidance policy allows ideas like this to proliferate and they're damaging ideas. So I think you've got that exactly right. Any other theories? Why else would he be holding back? I mean, I think that one kind of overarching theory of Warsh himself is that he is a very free markets oriented person.

20:51Katie Martin: And he just prefers anything where the government is doing less. So the kind of let markets do it for you is part of that. And another part of it is I think he wants to see more market volatility, right? He thinks that any kind of shadow cast over the markets by the Fed suppresses volatility, encourages wild speculation, depresses rates artificially, probably indirectly encourages fiscal spending by the government, all these kind of bad big government-y things. And so we're sitting here saying, oh, boo-hoo, all this volatility because Warsh won't say anything. It could well be that Warsh is saying to himself, great, this is exactly the outcome I wanted, right?

21:49Katie Martin: I want them to figure it out for themselves without help from me. And I want markets to be a bit more chaotic and a bit more scared because in the long term, those are healthier markets.

22:00Rob Armstrong: But again, if the 30-year yield goes to 5.5 or if the 10-year yield goes to 5%, I think there's a point at which you kind of, let's say, muck around and find out.

22:14Katie Martin: Yeah, and I think, by the way, it's an intellectually respectable view to say enough of this hand-holding. Let markets be a bit more chaotic. That's fine. But you have to say that. What you can't do is stand up in front of a room of journalists and all the millions of Americans watching on TV and say stuff about playing the ball rather than the referee, which is absolute nonsense. Listeners, that's what we think. But what are your theories for why Walsh is sitting on his hands? Unhedged at FT.com. Let us know. In the meantime, we're going to be back in one sec with Long Short.

22:56Okie doke, it is time for Long Short, that part of the show where we normally go long a thing we love or short a thing we hate. But we are revisiting a little bet that Rob and I had a few weeks ago on which would do better, Bitcoin or gold. About a month or so ago, we were asking which one of these cursed assets would do better. Because they were both doing terrible.

23:21Katie Martin: They both had been doing terrible. and actually the bet was about which was going to fall still further. Katie, you're hesitating to say what has happened. Do you know why Katie's hesitating, listeners?

23:33Rob Armstrong: Well, first of all, I was going to explain to listeners that you were the Bitcoin bro. You were the one saying you thought Bitcoin was going to do better. Yeah. And I was the gold girl saying I thought gold would do better. Winner, winner, chicken dinner is...

23:46Katie Martin: Rob Armstrong. It's Rob Armstrong. Yeah, Rob Armstrong. Rob Armstrong, for once. I always say that being a financial journalist is being wrong for a living. But this is one of those rare occasions where Armstrong is right. Bitcoin over the month that we that was the span of our bet. Bitcoin rose a few percent. Gold was flat. Armstrong, brilliant. Huzzah.

24:15But if I remember rightly, you were long Bitcoin on the basis that the charlatans and scoundrels wouldn't let it fall too far.

24:23Katie Martin: So I'm not sure it's a big sort of as everyone knows, it doesn't matter why you bet what you bet. What matters is being correct. I'm taking this moment of glory, Katie. I'm not going to let you diminish it.

24:35Rob Armstrong: Well, OK, you do your Bitcoin bro, you. That's, you know, that's your choice. so listeners Rob is the winner I am the loser but we're going to be taking a little break next week so no pods from us but we will have some lovely stuff in the feed to keep you entertained so keep on listening and we will be back after that Unhedged is produced by Jake Harper and edited by Brian Erstad our executive producer is Jacob Goldstein we had additional help from Topher Forehead special thanks to Laura Clark Greta Cohn and Natalie Sadler FT Premium subscribers can get the Unhedged newsletter for free. And a 30-day free trial is available to everyone else.

25:16Just go to ft.com slash unhedged offer. I'm Katie Martin. Thanks for listening.