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Kevin Warsh’s vow to rein in inflation has bolstered the new Federal Reserve chair’s credibility in financial markets, big fund managers say, helping to drive down investors’ expectations for long-term price rises.
Ten-year break-evens, which reflect the bond market’s view of long-run inflation, have dropped from above 2.5 per cent in mid-May to about 2.2 per cent this week, their lowest level in more than a year.
Investors say the shift reflects both the recent fall in oil prices to levels last seen before the start of the US-Iran war and the Fed’s hawkish turn at its meeting last week, where Warsh called “persistently high prices” a “burden for the American people”.
The tough rhetoric eased investor worries that Warsh might bow to pressure from Donald Trump to lower interest rates following the US president’s repeated tirades against former chair Jay Powell for keeping borrowing costs too high.
The drop in long-term break-evens had been “even more than you’d expect given the oil moves”, said Mike Riddell, a fund manager at Fidelity International, who added this was likely because the hawkish tone at the central bank “has given the Fed more inflation-fighting credibility with the market”.
The inflationary challenge facing Warsh was underlined by data on Thursday showing inflation rising to 4.1 per cent in May — more than double the Fed’s 2 per cent target — based on the Personal Consumption Expenditures Price index. Core PCE inflation — the Fed’s preferred gauge of longer-term inflation pressures — also edged up to 3.4 per cent.
But despite current price pressures, market expectations of future inflation have edged lower this week. A swap that measures average inflation over the coming 12 months, starting in a year’s time, has fallen by 0.12 percentage points to 3.88 per cent.
“The one-two punch of the hawkish [Fed meeting] and the tentative resolution to the Iran war have lowered perceived inflation risks, leading to a sharp leg lower in market-based measures of inflation expectations,” said Jon Hill, head of US inflation strategy at Barclays.
Despite the deal between Washington and Tehran to restore the flow of oil through the Strait of Hormuz, traders are continuing to bet on at least one quarter-point rate increase from the Fed this year, a stark reversal from the series of cuts anticipated before the war began in late February.
“If inflation broadly speaking improves between now and September, Warsh can get away with talking tough but not having to raise rates,” said Krishna Guha, vice-chair at Evercore ISI. “But if he’s in a situation where the data doesn’t clearly start to move that way by September, he will have to hike rates or risk losing his credibility.”
But some investors and economists believe the Fed may not need to deliver many rate rises if Warsh can convince investors he is an inflation hawk, pushing up borrowing costs in markets.
“Only time will tell if Warsh was essentially talking tough . . . in order to ensure he does not ultimately need to raise policy rates,” said Aaron Rock, head of rates at asset manager Aberdeen.
