The market trusts Warsh but households hesitate

Kevin Warsh has quickly convinced the market of his seriousness. At his first monetary policy meeting in June, he repeatedly emphasized to the central bank's commitment to bringing inflation back to the 2 percent target. Since then, the market's inflation expectations have since fallen below the levels that prevailed before the war between the United States and Iran. The sharp drop in oil prices has contributed to this, but the decline also reflects confidence that the new Fed leadership takes price stability seriously (Bloomberg). At the same time, many speculative investors have positioned themselves for higher US short-term rates (CFTC).

Over the past week, however, the tone has shifted. At the ECB's conference in Sintra, Warsh adopted a softer tone than at his debut and noted that inflation risks have decreased over the past month. The following day, the June jobs report came in well below expectations. Employment rose by just 57,000, compared to an expected figure of just over 110,000, and figures for previous months were revised down (BLS). Consequently, the market is therefore no longer pricing an October rate hike as certain, although at least one rate hike this year is still anticipated.

The jobs report reveals important about how the market views inflation. If a central bank that stays on hold while core inflation remains above 3 percent, it is taking a risk. If price increases prove to be more persistent than expected, the Fed may have to raise interest rates considerably later on. Therefore, the market could have interpreted the weak report as a reason to demand higher compensation for future inflation. This did not happen. Inflation expectations were largely unchanged after the report, showing that the still expects inflation to return to target.

The next test comes on July 14, when the CPI for June is published. The Cleveland Fed's forecasting model points to a slightly negative monthly reading, which would confirm that this spring's energy-driven rise in prices was temporary rather than the beginning of a larger trend (Cleveland Fed). If the figure is as expected, today's ten-year yield of 4.5 percent looks like an attractive level for those who want to extend duration. Moreover, Warsh has never explicitly stated that price stability requires higher interest rates. He has described the rate path as written in pencil, and the five task forces he has set up to review the Fed's analytical work will deliver their conclusions until the end of the year. Until then, the committee can wait and let the temporary energy effects fall out of the inflation figures on their own.

However, there is one group that does not share the market's confidence in the new Fed chairman, namely American households. According to so-called inflation swaps, inflation over the next year is priced at around 2.2 percent in the market. Meanwhile, the N2wew York Fed's household survey meanwhile sits just below 3.5 percent (Bloomberg). This gap is unusually wide, and history does not favor the market. Over the time, household expectations have over time tracked actual inflation more accurately than market pricing, which on several occasions in recent years has priced in a decline in inflation that never materialised.

There is also a structural problem. Some prices, such as hotel rooms and restaurant meals, fall when interest rates rise because demand cools. Others, such as healthcare and insurance, are barely affected by the level of interest rates. According to the San Francisco Fed, it is precisely the rate-sensitive prices that have already slowed, while the insensitive ones continue to rise. In other words, higher rates would hit the wrong part of inflation. If households are correct, this summer's bond rally may prove premature, and a central bank that waits too long may have to raise rates considerably once it finally acts.

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