What a Quieter Fed Could Mean for Markets

In his first meeting as Fed Chair, Kevin Warsh signaled restraint in providing guidance. Our Global Head of Fixed Income Research Andrew Sheets looks at possible impacts of the new approach.Read more insights from Morgan Stanley.----- Transcript -----Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley. Today, why the Fed could do less than expected and why that could still lead to more volatility. It's Wednesday, June 24th at 2pm in London. Last week saw the first meeting of the Federal Reserve under its new chair, Kevin Warsh. It didn't disappoint. The Fed’s Summary of Economic Projections saw significantly higher inflation than the last iteration in March, and in turn, a much stronger case to raise interest rates, perhaps multiple times. The Fed's statement, which laid out its views around the economy and its reasons for action, was changed dramatically – and also significantly shortened. We don't think the Fed will ultimately follow through on the interest rate rises that were flagged in this meeting and will choose instead to remain on hold this year. But we think this scenario of them staying on hold can still lead to more volatility. I'll try to address each side of this apparent contradiction. First, the Fed is clearly worried about inflation, which has been elevated for a considerable period of time. But working through the numbers, Morgan Stanley economists forecast lower inflation over the rest of this year than the Fed now expects. And so, while we think it would be entirely reasonable for the Fed to expect to raise interest rates based on the high inflation that they have penciled in, we think they could reach a different conclusion if our lower estimates are ultimately correct. Supporting our case, at least in our view, is that energy prices have fallen significantly in recent weeks since some of these Fed forecasts were set, as markets have moved to believe not only would existing oil production resume in the Persian Gulf, but Iran could increase exports materially under its new agreement with the United States. That would greatly reduce a source of underlying inflationary pressure in the U.S., Europe, and Asia. With inflation set to come in lower than feared, we think the Fed's most natural option will be to remain on hold this year rather than raise rates. But if the Fed's not doing anything, how exactly is that going to drive volatility? Our answer to that question lies in another thing that it's not going to be doing – providing as much information about where it thinks monetary policy is going next. Indeed, since the financial crisis, the Fed often went out of its way to give so-called forward guidance and significant detail about when and how they may change policy in the future. Proponents saw this as a way to avoid surprises and smooth the transmission of this policy, but critics saw it as limiting and potentially giving markets a false sense of certainty. The new Fed chair, Kevin Warsh, is one of these critics and has promised to give a lot less forward guidance. That lack of handholding by the Fed about what they might do next is a big change. Coupled with the potential for a smaller Fed balance sheet and big questions around the path of inflation and the impact of AI and productivity, every data point now has more potential to shift the market's thinking. My strategy colleagues think that this will lead to higher volatility in two-year interest rates, as well as more volatility in currencies. I'd also note that here in the UK, this paradox is not nearly as puzzling. Here, the Bank of England's target rate has been the same level since mid-December. But that hasn't stopped the UK two-year bond yield from trading in an over 100 basis point range. Thank you, as always, for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.