Last Wednesday, the Federal Reserve voted 12-0 to raise its benchmark interest rate by a quarter percentage point to a range of 3.75% to 4.00%. Newly appointed Fed chair Kevin Warsh delivered the unanimous message and followed up with an unusually brief question and answer session. It was the first hike in interest rates since July 2023, signifying an important change in policy direction. During the last two decades, we have had three prior chairs of the Federal Reserve: Ben Bernanke (2006-2014), Janet Yellen (2014-2018), and Jerome Powell (2018-2026). Each directly influenced the economy through both monetary policy and managing the size and scope of the central bank’s balance sheet. Given that this was Warsh’s first real opportunity to put his own stamp on the Fed, we were all ears. Several things stood out.
Chairman Warsh repeatedly pushed back against reading into any specific piece of economic data. Instead, he spoke about data being noisy and trends providing information. Historically, market participants have been able to cling to certain “preferred metrics” that the aforementioned chairs paid more attention to. Warsh’s approach is harder to pin down and leads to a wider range of projections. He doesn’t like giving forward monetary guidance, nor did he provide his own economic forecast. He relayed those of the board but kept his personal opinions close to the vest. There is an opacity to Warsh that is different.
While he was vague on policy, he was very clear about his priorities. Warsh spoke repeatedly about price stability and how important it was to those in the bottom half of the economy. He pointed out that those who live paycheck to paycheck are most harmed by inflation. They are also unlikely to have significant assets, so they don’t benefit from asset price inflation driven by financial repression (keeping interest rates below the rate of inflation – which was most prevalent during the GFC and COVID). Our interpretation is that he is willing to raise rates higher than prior chairs and is more concerned about stable prices and keeping bond yields in check than concerning himself with how the stock market might react to that. The prioritization of price stability over price appreciation would be a meaningful departure from the last seventeen years.
There has been precisely one instance in modern American history where the Federal Reserve hiked only one time. The odds are high that we are now in a new rate hike cycle. Currently, the market is pricing in three additional hikes by the middle of 2027. Our main concern about higher rates is that Fed policy may not be the appropriate tool for addressing the two biggest drivers of inflation: price shocks related to conflict in the Middle East and the AI infrastructure buildout. War-related supply shocks have driven diesel fuel, which is an essential feedstock for the global supply chain, to an all-time high of $6.50 per gallon. When it comes to the buildout of data centers and their corresponding infrastructure, we wonder whether higher rates will slow the pace of spending by the most cash generative companies in the world. At the same time, interest rate sensitive sectors like autos and housing are already struggling from the highest interest rates in a quarter century. The Fed’s tools are blunt – and one size does not fit all.
A number of clients have asked us recently if we are “alarmed” by the move in interest rates – as if something in the system isn’t working properly. While we worry about most things most of the time, we don’t view the leg higher in rates through that lens. While it may feel like rates are rising uncontrollably, the reality is that interest rates have been decreasing for forty years. The bottom in rates occurred during COVID at the peak of financial repression. What we are seeing now is, in part, the cost of the incredible amount of liquidity created during the great financial crisis and COVID. We continued to believe that structurally higher interest rates will create an environment where fixed income will become an increasingly important and contributive part of our clients’ portfolios.
Higher rates tend to sow the seeds of their own demise. If rates move high enough, they slow the rate of economic activity. This is what defines an economic cycle. The fact that we haven’t had a proper one for the last twenty years does not prove their lack of existence. The question for us is whether this particular rate hike cycle ends up in a slowdown or a recession. We continue to believe that the answer rests on what happens in the Middle East. If hostilities end, fewer rate hikes will be required. An end to hostilities remains our biggest positive catalyst for the markets moving forward.
The Hanson Slater Power Group
Baird
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Seattle WA 98104
206 664-8888
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