Beneath the surface, however, it is all change. A new Federal Reserve (“Fed”) chair, rising inflation, and continued instability in global energy prices make it difficult to parse the signal from the noise and draw long-term conclusions. This (perennial) problem is what we aim to address here.
The last meeting
The April meeting of the committee was overshadowed by data indicating stubborn inflation and ongoing uncertainty in the labor market. The decision was the first time since 1992 there have been four dissenting votes, with even the dissenting group pulling in different directions (dovish vs hawkish).[1]
The main point of contention appears to have been around the wording of the Fed’s forward guidance, which still implied that monetary easing is a possibility.[2] According to the meeting minutes, ‘a majority of participants’ agreed that policy firming might become appropriate if inflation remains elevated above the 2% target.[3]
Data that has emerged since the meeting confirms that both inflation indices (CPI and PCE) are rising, even with energy costs stripped out. The market interpreted this as a sign that no rate cuts will take place this year.[4]
The data
While unwelcome, none of the data indicates a severe problem, especially if we consider the geopolitical context and historical trends. It is true that inflation is trending upwards, but this is not unexpected considering the combination of sustained tariffs and oil price uncertainty.
In the broader scheme of things, inflation is still relatively low, as is unemployment.
Source: Federal Reserve Bank of St. Louis
Source: Federal Reserve Bank of St. Louis
The tension largely stems from the possibility of severe repercussions (such recession, or a genuine spike in inflation) combined with the political drama surrounding former Chairman Jerome Powell’s departure and the arrival of his replacement, Chairman Kevin Warsh, confirmed on May 13th.
The incoming chair
Chairman Warsh presents a challenge for markets to digest. His philosophy differs from that of Powell in various respects. A longstanding opponent of QE, he is in favor of reducing the Fed’s balance sheet - a highly consequential measure for banks and the businesses to whom they lend.[5]
His firm belief in the potential of AI to boost American productivity means that he is logically more open to cutting rates.[6] Productivity growth is naturally counter-inflationary, as it reduces the amount of labor required per unit of output. A tighter job market therefore does not lead to higher inflation.
Conclusion
Much of the commentary is focusing on the political dimension of the current situation: such as Powell’s decision to remain as governor, or Warsh’s stated disdain for Fed officials ‘speaking too much’ and his general aversion to forward guidance.[7] The implications of these are not only unpredictable, but ‘noisy’ - that is, unlikely to be important a year from now.
This point about productivity - what it means for the economy, interest rates, and US debt - is perhaps the most ‘signal’-like issue at play.
In the 1990s, many were concerned that the economy was overheating and rate hikes were necessary. Fed Chair Alan Greenspan listened to arguments that technology-led improvements in productivity would more than offset a constrained labor market. He was proved right.[8]
Some would argue - Chairman Warsh among them - that we are standing on the cusp of a new era, compared to the internet revolution of the late 90s, thanks to the standardization of AI in our personal and working lives.
Even if this does not materialize as quickly or as dramatically as is claimed, being open to the possibility of disruption - especially positive disruption - is an important defense against allocating for a previous era when the new one has all but arrived.
