Warsh era at the Fed begins with rate pause amid spiking inflation

The Federal Reserve on Wednesday left its benchmark interest rate unchanged at a target range of 3.5% to 3.75%, marking its fourth consecutive pause as it enters the Kevin Warsh era.

Monetary policy watchers, however, have changed their forecasts on the Fed’s next moves as they react to an economic landscape that has shifted dramatically since the start of the year amid rising inflation and a developing U.S.-Iran peace agreement.

The Federal Open Market Committee (FOMC) maintained its policy rate in a unanimous 12-0 vote.

“Economic activity is expanding at a solid pace despite elevated uncertainty that owes, in
part, to the conflict in the Middle East,” the FOMC said in a statement. “Productivity growth and capital investment are strong. Job gains have kept pace with the workforce, and the unemployment rate has changed little. Inflation remains elevated relative to the Committee’s 2 percent goal, in part reflecting
supply shocks that have driven price increases in certain sectors, including energy. The Committee will deliver price stability.”

On the macroeconomic front, inflation was running at an annual rate of 4.2% in May — more than double the Fed’s 2% target — driven in part by higher energy prices. Meanwhile, the labor market continues to show resilience, with the U.S. economy adding 172,000 nonfarm payroll jobs in May. 

“At the beginning of the year, markets expected the Fed to begin cutting rates by midyear as inflation cooled and labor market conditions softened,” First American deputy chief economist Odeta Kushi said in a statement. “Markets have largely abandoned the idea that easing is the default path. The conversation has shifted from ‘When will they cut?’ to ‘Will they cut at all?’”

Policymakers must now determine whether recent price pressures are temporary or likely to become more deeply embedded in the economy. As long as labor market conditions remain stable and inflation stays above target, policymakers have little urgency to lower rates, Kushi said.

Charles Goodwin, vice president and head of bridge and DSCR lending at Kiavi, pointed to the labor market’s continued strength as a key factor behind the Fed’s decision.

“The latest jobs report indicated stronger-than-expected economic performance, reducing the likelihood of a near-term Fed rate cut and reinforcing a higher-for-longer interest-rate environment,” Goodwin said.  

Precautionary rate hikes?

While investors in April largely expected the Fed to maintain current rates through the end of the year, about 7% now anticipate a rate hike in July and 30% expect one in September, according to the CME Group’s FedWatch tool.

Some investors are even beginning to price in the possibility of several rate hikes this year. In its midyear market outlook, asset manager PGIM warned that inflation risks remain elevated while the labor market appears to be somewhere between stabilization and reacceleration. 

As a result, the firm expects the Fed to raise rates three times this year to “shore up institutional credibility and anchor inflation expectations.”

“Our sense is that there will be political cover if the rate hikes are framed as a ‘precautionary’ response to supply-side inflation and recent volatility in long-term Treasurys,” PGIM wrote in its report. “We expect the Fed to reverse these hikes relatively quickly with three rate cuts in 2027 and one additional cut in 2028, resulting in a terminal rate of 3.375% — slightly below the current rate and likely close to the neutral rate.”

For the mortgage industry, however, a potential peace agreement with Iran plays a large role. 

“If a long-term deal is implemented and honored, inflation expectations could fall, pulling bond yields and mortgage rates lower as well,” said Dave Meyer, chief investment officer at real estate investing platform BiggerPockets. 

According to Kushi, mortgage rates are influenced far more by inflation expectations and Treasury yields than by the Fed’s policy rate itself.

“While the recent decline in Treasury yields is encouraging, a meaningful and sustained reduction in borrowing costs will likely require more than easing geopolitical tensions,” Kushi said. “Persistent federal deficits, elevated debt issuance and lingering inflation concerns continue to put upward pressure on long-term interest rates, reinforcing a higher-for-longer borrowing-cost environment.”

Joe Panebianco, CEO at AnnieMac Mortgage, added that now that oil has fallen sharply following the preliminary agreement with Iran, lower energy prices remove a major near-term inflation risk. But it is too early for the Fed to declare victory while energy flows remain disrupted.

“Counterintuitively, the clearest path to lower mortgage rates may be a Fed that stays firm. If its guidance reduces the inflation premium embedded in long-term Treasuries, the 10-year yield and mortgage rates can move lower even without a rate cut,” he said.

Editor’s note: This is a developing story and will be updated.