The Fed is expected to hold rates steady. Warsh will have to explain why

Persistent price pressures complicate the Fed's rate outlook as energy costs, tariffs and AI-led spending sustain demand

By Colby  smith

 

Kevin M Warsh wants inflation to move more swiftly back to the Federal Reserve’s (Fed’s) 2 per cent target. But on Wednesday, the central bank chairman and his colleagues are widely expected to hold interest rates steady. 

The discrepancy is poised to be a focal point at the latest meeting, which is taking place just days before midterm elections that will decide who controls Congress in the latter half of President Trump’s second term. 

Since officials voted unanimously in September to raise rates by a quarter of a percentage point to 3.75 per cent to 4 per cent, the incoming inflation data has been anything but reassuring. Energy prices are up across the board as the war with Iran has dragged on. The range of goods and services growing costlier appears to be broadening. And a splurge in spending tied to the proliferation of artificial intelligence (AI) shows little sign of abating. 

The Fed’s other priority, the labour market, has also remained stable, despite monthly growth slowing in September, a sign that Fed’s policy settings are not excessively onerous for the economy. 

Numerous Fed policymakers have already indicated their support for a rate increase at their final gathering of the year in December in pursuit of a “timelier” return to the 2 per cent target after six years of overshooting it. So the question for Warsh at Wednesday’s news conference is: why wait? 

Warsh had the last word ahead of the upcoming rate decision. Speaking in Bangkok at the annual meetings of the International Monetary Fund (IMF) and the World Bank this month, the chairman did little to change the narrative laid out by a number of his fellow policymakers in the preceding weeks. The overarching message was that the central bank had more work to do to tame inflation, but there was no urgency to raise rates at consecutive meetings. 

But for a broad swathe of economists and investors, the primary reason a rate increase was not pencilled in for October, despite hotter-than-expected inflation data, was precisely the steer provided by Warsh’s colleagues. Recent jitters in financial markets amid concerns about the sustainability of the AI boom have also helped. That has made financial conditions, which measure the availability of credit in the economy, only slightly less accommodative than before. 

But looking solely at the inflation data, Riccardo Trezzi, a former Fed economist who runs the research firm Underlying Inflation, said a rate increase was clearly justified on Wednesday. 

“There is zero evidence of cooling down,” he said of current price pressures. Trezzi estimates that the Fed’s preferred inflation gauge, which strips out volatile food and energy items, will reach 3.4 per cent in December. At the same time last year, it stood at 3 per cent. Overall inflation, as measured by the Personal Consumption Expenditures (PCE) price index, is projected to reach 3.8 per cent, according to Trezzi’s calculations, nearly double the 2 per cent target. PCE data for September will be released on Thursday, the day after the Fed’s decision. 

“There’s a disconnect in terms of how the Fed sounds at the moment,” he said. “They still have to make up their minds whether they’re really serious about disinflating the US economy.” 

The issue for the Fed is that the primary sources of resurgent inflation are beyond its control. Beyond the Iran war and Trump’s tariffs, both of which have added to price pressures, many of the biggest AI companies fuelling growth also appear impervious to higher rates. 

Perhaps the biggest driver of demand right now is the sharp rise in wealth across the country generated by stock market gains, said Marc Sumerlin of Evenflow Macro, an economic consulting firm. 

In the last four quarters, households’ net worth rose roughly $20 trillion, according to Fed data as of September. While most of these gains have accrued to high-income households, this group drives the bulk of consumer spending. 

Estimates vary on how much the Fed will need to squeeze the economy in the coming months to begin turning the tide on inflation. Some believe price pressures will begin to ease as the impact of Trump’s tariffs and the energy shock fades, removing the need for an aggressive response from the Fed. But others believe a more forceful approach might be required. 

The first of two wild cards is how financial conditions evolve in the coming months. US government bond yields are sharply higher today than they were just a few months ago for a variety of reasons. Some of that reflects changing expectations about how much the Fed will need to raise rates as growth has picked up. There is also intensifying competition between governments and companies for capital as large AI companies borrow aggressively to fund their expansions. 

Investors also appear to be demanding extra compensation to hold longer-dated debt rather than shorter-term securities amid persistent concerns about Washington’s fiscal profligacy and fluctuating worries about the Fed’s ability to operate independently, said Ellen Zentner, chief economic strategist at Morgan Stanley Wealth Management.  

Rising yields will marginally help the Fed pursue its inflation goal, but that will not entirely replace the work the central bank has to do to raise rates to at least a neutral level, which neither speeds up nor slows down the economy, Zentner said. 

The second wild card is how the public perceives the Fed’s grip on inflation. Concerns about price pressures in the year ahead have mounted, but longer-term indicators look more benign.  

For now, that has afforded the Fed some flexibility over when it must deliver additional increases, said Raphael Bostic, who served as president of the Atlanta Fed for nine years until February. But “there are limits”, he warned.