Chairman Kevin Warsh delivered the Federal Reserve's first interest rate increase since 2023 last week, a unanimous quarter-point hike that marks a critical turning point as inflation remains stubbornly above target at 3.7%. The move comes as Wall Street signals expectations for more tightening ahead, with the 2-year Treasury yield trading nearly a full percentage point above the effective federal funds rate on Wednesday—the largest spread since 2023.
Inflation has run above the central bank's 2% target for more than 5½ years, measured by the Fed's preferred personal consumption expenditures indicator. That persistent price pressure is forcing Warsh to prioritize rate hikes over his long-standing goal of cutting the Fed's $6.7 trillion balance sheet, a priority he's championed since at least 2011.
A New Framework Takes Shape
Warsh is gradually articulating a new regime for determining policy that relies heavily on financial conditions and market indicators. He's mentioned "financial conditions" three times in his Jackson Hole, Wyoming, speech and three more times in his most recent news conference on Sept. 16. He said a review of market conditions indicated to him that conditions weren't restrictive.
That framework includes "the level and change in asset prices across sectors ... the prices and trading volumes of Treasury securities ... the foreign exchange value of the dollar ... the cost and availability of credit ... and the price of a broad set of commodities," Warsh said in Jackson Hole. "These and other indicators should inform the Fed's near-term outlook on economic activity and inflation throughout the business cycle. They should also reveal the state of broader financial conditions ... and the risks and uncertainties in the financial cycle."
The approach is more intense than previous chairs and somewhat reminiscent of former Fed Chair Alan Greenspan. Warsh is watching a suite of indicators for monetary expansion including credit spreads, the Fed's Senior Loan Officer Opinion Survey, which gauges the willingness of banks to lend, and credit availability and demand. His conclusion: money is easy.
"That helps explain the growth we've seen this year in those loans," he said. "Credit and loan markets are showing few signs of policy restraint." He added, "We should pay attention to money created by the central bank and money that comes from the banking and financial systems."
Market Signals Point to More Hikes
Continuing loose credit conditions clear the way for further rate increases in Warsh's framework, but hikes will likely come only if inflation remains high along with oil and diesel prices. The Bloomberg Commodity Index is up more than 30% this year. Diesel has risen 83%.
"The recent rise in overall commodity prices also bears watching," Warsh said at Jackson Hole.
Markets are pricing in a 70% probability of a follow-on hike in October, with as many as two more priced in from now until March. The stock market remains buoyant, the labor market is robust, most financial conditions indicators continue to show little restraint, and growth looks strong.
Warsh's comments at his Sept. 16 news conference caused consternation among some in the central banking world. He dismissed the idea of describing the funds rate as accommodative, neutral or restrictive, saying the concept is "useful academically" but had no bearing on the decision to hike.
Economist Claudia Sahm wrote, "What is odd is that Warsh framed the decision as 'removing a dose of accommodation' and then distanced himself from the concept that defines accommodation," and asked, "But now that the Fed has hiked, how will he judge whether to hike again, and when to stop?"
Balance Sheet Cuts Remain on Hold
Reform has been slowest on Warsh's longest-standing policy priority. He quit his first stint on the Fed's board 15 years ago because he was uncomfortable with the growth in the balance sheet, though he said he voted for expanding it out of loyalty to the institution.
Back in control of the Fed's agenda, Warsh still can't quickly follow through on his plans for balance sheet cuts, even though that could in theory have taken more accommodation out of the economy. The FOMC's minutes for July show other voters were reluctant to move quickly toward cutting the balance sheet, preferring to wait for Warsh's task forces to report back. He has appointed five task forces to examine Fed practices, with reports due early next year.
The state of the economy and the markets also may have complicated his plans. With inflation above the Fed's target and oil surging, the committee had an immediate need to address prices, making it the wrong time to experiment with whether Warsh was right that cutting the balance sheet would meaningfully restrain the economy.
Meanwhile, the yield on the 10-year Treasury has risen above 5%, pulling up rates on mortgages and other consumer debt with it. That makes this a particularly inopportune time for the Fed to start asking the market to take on additional supply of mortgages and Treasury notes if the Fed were to reduce the balance sheet.
Warsh has made some visible changes at the Federal Reserve, shortening the news conference after meetings of the Fed's rate-setting Federal Open Market Committee and changing the seating arrangements for reporters to be alphabetical by news organization. Those changes are cosmetic, but they mask a more profound shift in how Warsh thinks about and communicates monetary policy.
It's unclear whether other members of the FOMC have cast off the neutral framework and adopted one more closely aligned with Warsh's broad concept of financial conditions. Former Fed Chair Jerome Powell often noted how difficult it was to determine the neutral rate, but still often described rates as "modestly restrictive."
So far, Warsh has been virtually alone in refusing to forecast the outlook for the funds rate in the Summary of Economic Projections, the so-called dot plot. Many board members also continue to offer their outlooks for the economy and rates in speeches and interviews, a practice Warsh has rejected.
Why This Matters:
Warsh's rate hike answered critics who questioned his independence from President Donald Trump and demonstrated the Fed's commitment to price stability after more than 5½ years of above-target inflation. His market-focused framework represents a return to discipline after years of experimental monetary policy that expanded the Fed's balance sheet to $6.7 trillion. The approach emphasizes observable market signals over theoretical constructs like the neutral rate, which can't be measured directly and has led to policy errors in the past. If inflation remains elevated and credit conditions stay loose, markets are pricing in additional hikes that could finally bring price pressures under control. But the rise in the 10-year Treasury yield above 5% shows how aggressive tightening affects borrowing costs for families and businesses, creating tension between the need to restrain inflation and the risk of overtightening. Warsh's reluctance to cut the balance sheet immediately, despite his long-held views, reflects the practical constraints facing any Fed chair when inflation threatens economic stability.