Federal Reserve Chairman Kevin Warsh convinced markets with a few carefully chosen words that he was serious about inflation and ready for a rate hike in weeks. However, the road to a rate hike still appears fraught with difficulties, and there are still plenty of reasons to convince Warsh and his central bank colleagues that it's not necessary to act now.

A dramatic reversal in expectations: from "we'll talk about it at the end of the year" to "we'll add it in September."

Warsh's keynote speech at the Federal Reserve's annual Jackson Hole symposium in Wyoming last Friday (August 28) completely reversed market expectations for interest rates. Previously, the market anticipated a low probability of a rate hike until at least December, but after the speech, a rate hike at the Federal Open Market Committee (FOMC) meeting in just over two weeks became highly probable. However, some observers warned that the hype surrounding a rate hike was unfounded. Treasury Secretary Scott Bessent stated on Monday on the sidelines of the G20 summit in Asheville, North Carolina: "I think what we're seeing is a supply shock, and traditionally you don't raise rates during a supply shock unless you see second- or third-order effects. And what we're seeing is that core inflation has remained very, very restrained." While acknowledging that recent inflation data has been soft, Warsh stated that this progress is insufficient and "can't tell me that the underlying trend has improved significantly." He added, "We have to be sure that underlying inflation is moving clearly and quickly enough toward our target. Otherwise, we have work to do."

The probability of an interest rate hike jumps to 66%, but disagreements remain.

The combined effect of these remarks was a sharp repricing of the probability of an interest rate hike. According to the CME FedWatch Tool, the probability of a rate hike at the September 15-16 meeting rose to 66.1% on Monday, almost double what it was before Warsh's speech. However, Warsh had previously made hawkish comments on the Fed's inflation mandate, though he offered less guidance on what constituted an appropriate response. At a July press conference, he pledged that the Fed would not waver in its pursuit of 2% inflation. However, the market did not interpret this pledge as genuine commitment, pushing up Treasury yields and decreasing the probability of a rate hike. In fact, Citigroup economist Andrew Hollenhorst wrote in a client report that Warsh's comments last Friday were "relatively uncontroversial; Warsh reiterates what he does in every speech." He characterized Warsh's remarks as more hawkish than usual, "but only slightly hawkish," especially given that economic data did not indicate a particularly urgent need for monetary policy tightening. He predicted: "There was no consensus on raising interest rates at the July FOMC meeting, and data since then has shown cooling inflation and slowing hiring. There will likely be no consensus on raising rates in September either. We expect inflation data to continue cooling, making a rate hike unlikely this year."

Two Data-Intensive Weeks: Employment and Inflation to Be the Judges

Ahead of its next meeting, the Federal Reserve has several key data points to digest. This week will see the release of a crucial jobs report, with growing skepticism about the labor market following three consecutive weak non-farm payroll data releases. The following week, just before the Fed meeting, will see the release of the Consumer Price Index (CPI) and the Producer Price Index (PPI). In addition, several housing reports will be released, along with retail sales data to be released on the day of the Fed's interest rate decision. David Kelly, chief global strategist at JPMorgan Asset Management, said the most important factor is the employment picture, which could deter the Fed from raising interest rates. In his weekly market report, Kelly wrote that recent data suggests "the economy doesn't have as much momentum as Kevin Warsh implied in his Jackson Hole speech." He added, "Given this, it may be premature for the market to now assign a 60% probability of a September rate hike… While investors should prepare for potential policy missteps, there are few signs in the labor market indicating future inflation troubles."

Bank of America maintains its stance of three rate hikes, trusting Warsh's credibility.

Despite this, the market remains confident: Warsh's Fed is poised to act after three FOMC voters supported a rate hike at the July meeting. Meanwhile, Bank of America maintains its forecast of three more rate hikes, stating that Warsh's Jackson Hole speech presented the market with a "more credible Fed." Bank of America economist Aditya Bhave stated in a report, "The key takeaway for us is that Warsh raised the bar for holding rates steady, arguing that the Fed should focus on trends rather than isolated data points, and that underlying inflation has not improved significantly." He added, "Unless there is a major downside surprise, the responsibility now rests on Warsh to deliver on the September rate hike. Otherwise, in our view, he risks undermining the credibility he gained last Friday."

Conclusion

A speech nearly doubled the probability of a September rate hike; however, the Treasury Secretary's warning that "supply shocks should not lead to rate hikes," persistently weak employment data, and Citigroup's prediction that "there will be no rate hike this year" have put the brakes on this rate hike train. Warsh regained the market's trust with his firm rhetoric, but also backed himself into a corner where he "must deliver on his promise in September." The employment and inflation data in the next two weeks will be the final judge in determining whether he will follow through on his words or just make empty promises.