The Fed is in no rush, markets are back to working for it

The Fed kept its rates unchanged, and it was no surprise to anyone. David Zervos, the new advisor to Scott Bessent, celebrated that the decision did not move the needle. Neither long-term rates nor the stock market budged an inch because of it (in a week that was as volatile as few, ending with sharp declines on Thursday and Friday). The Treasury, unofficially, of course, celebrated that the Fed had eliminated "forward guidance" -- the advance communication of its next steps -- and that the turbulence predicted by critics did not occur. Let it be clear, what Kevin Warsh suppressed from day one of his management returned through the window, also unofficially. Theory and practice differ at this point and (it’s worth keeping in mind) in many more.{#p-1793577977082-24605}

The Fed reports that the economy and inflation are growing exuberantly while it remains with its arms crossed. No one was surprised. A prior warning was received from three prominent officials of the central bank (in a personal capacity): Williams, Jefferson, and Waller. They should have telegraphed it when the storm -- the tantrum of the bond curve -- threatened to take away their control of monetary policy. The curve calmed down, and the markets do not rest in peace. What once thrilled them now also worries them: the rise and excess of AI. They face new shocks that are, if you will, more favorable for good coexistence between the Fed and the Treasury.{#p-1793577994386-29860}

The United States grew 3.4% in the third quarter. Private consumption expanded 3.8%. "The economy is not overheating," said Warsh at the press conference. Final sales to the domestic private sector suggest otherwise: +4.9%. In favor of the chairman, it could be noted that the pace is not sustainable. The disposable income of families (+2.3%) is increasing more slowly. And they are burning savings to finance the gap. Still, the vertigo does not cease. The real-time forecast from the Atlanta Fed, with the data available as of today, anticipates a growth of 3.2% for the fourth quarter. Potential GDP, the speed of transit compatible with inflation in line with the 2% target, is also set at 2%, according to the definitions of the Fed itself.{#p-1793577977082-37148}

"Inflation remains elevated," states the official communiqué. It is so. And it accelerates: it rose two-tenths in September compared to August. The personal consumption deflator showed a reading of 0.5% monthly and 3.6% year-on-year. Core inflation, which excludes energy and food, remained at 0.3% monthly. And it climbed one-tenth to 3.1% in the last twelve months. However, not everything is deteriorating. The median, a measure of central tendency, has persisted at 0.2% since the beginning of the year. Its year-on-year variation (2.7%) is two-tenths lower than in May. "The Fed will not accept an inflation target higher than 2%," declared Warsh. But it does tolerate inflation orbiting sustainably above the target. The chairman, who likes to see himself as a hawk, promises to bring it back to the 2% corral. That said, the current dot plot, which the central bank published in September, estimates that it will not achieve this before 2028.{#p-1793577977082-19344}

The economy and inflation are racing ahead at great speed. The Fed has a dual mandate. It must not only pursue price stability but also ensure full employment. However, employment is not a problem. It hits the precise target: 4.2%. It is inflation that has put it offside. There have been no interruptions since 2021. Even more: Warsh is a fierce critic of the inherited policies. Hence, the million-dollar question. Why wasn’t the meeting used to issue a ticket for speeding? Specifically, the central bank raised the fed funds rate by a quarter point in September; why didn’t it trigger again in the meeting? The statement, Warsh’s speech, all the data confirm the theory that prescribes greater monetary restriction. The practice was not to execute it (as we already knew). It is worth noting that the decision was not unanimous. There were two dissenters: Governor Lisa Cook (whom President Trump intends to fire and the Justice Department keeps in office) and the head of the Cleveland Fed, Beth Hammack, who asks her colleagues for a faster reaction and is refuted for the second time.

Warsh defends the resolution (“I feel good about the signals”) that inflation expectations are behaving correctly, that he is encouraged by the progress that “we have achieved,” that the overwhelming consensus is that “the applied monetary medicine has yielded results” even if they are not sufficient, and that the period ahead is rich in information. The idea is to analyze it first and decide the appropriate steps afterward. Warsh’s Fed broke the undefeated streak and the doubts about its independence from the interference of the Trump Administration - with the rate hike in September. The restored credibility buys time. Markets strongly shape the vision of a banker like Warsh. "Since early September, we have observed that, both inside and outside the tech sector, interest rates have had effects." Financial conditions are stricter, although "I cannot -- nor am I willing to -- label them as 'restrictive'," he stated. "Market participants are becoming more selective in their capital allocations," he noted. This "selectivity," so to speak, deepened with the severe punishment on Thursday and Friday. The Fed is paying attention. AI funding and credit spreads are on the radar, he said.
Photo: White House

What will the Fed do in December?

Warsh avoided the answer. It has already been said: he suppressed the advance communication of his steps. But unofficial spokespeople -- Williams, Jefferson and Waller -- who have already proven accurate, and the dot plot, which is official although it currently lacks the chairman's contribution, indicate there the second rate hike. Under the condition ceteris paribus. That is, if everything else remains constant. At the CME, fed funds futures assign a 70% probability. The deluge on Thursday and Friday lowered the perception. When it calms down, if there are no irreparable damages, they will tend, sooner or later, to readings close to 90%.

The unofficial forward guidance leaves little room for doubt. On Friday, with the Nasdaq down 3% and crude oil above $100 a barrel, Alberto Musalem from the St. Louis Fed advocated for a "soon" rate hike as inflation risks persist. Lorie Logan from the Dallas Fed pointed out that at least two more hikes (of a quarter point each) are required. Skipping a meeting does not make a big difference, she said, as long as the Fed emphasizes the destination of its monetary policy. The pause allows time to adjust to higher rates and "reduces the risk of economic activity deteriorating more than necessary." Tom Barkin, president of the Richmond Fed, reiterated this idea. The cadence can be discussed, but not the direction of the process. In other words, the Fed will raise its rates, but it has chosen gradualism over a shock strategy.

The Fed is in no hurry. It is lagging behind inflation and events, but the bond curve has calmed down and no longer objects to its timing or pulls it. Events are reversing and shortening the distance it still has to travel. The 10-year rate has fallen 43 basis points since its peak on October 10 and is retreating below 5%. Inflation is rising due to war and energy shortages. Inflation expectations remain firmly stable. The Fed will have to act, of course, to confirm that they are right. But it is not an urgent task since it is known that the old school, which enjoys credibility, remains in charge.

The fierce rate hike since March is a real rate increase. And the capital expenditure of AI, along with its increasing leverage, are the engines behind the rise. Suddenly, but rightly, markets became obsessed with revising business plans. The entire chain. Capex, cash flows, financing, and returns on investment. What are the barriers and competitive advantages of the pioneers that will allow them to retain profits for themselves? AI is at the altar. Its enormous transformative capacity is believed in, and there is discussion about whether the chosen path is viable. And everyone, even the big players, is taking the exam. Thoroughly. Just look at the blows that Meta, Alphabet, and Amazon received. Or Intel. Or the meager harvest of funds in the last round of Open AI. In July, markets forced the Fed to get moving. Hence, the September fed funds hike. Now they are forcing AI giants to recalculate and moderate their frenzy (or better capitalize their initiatives). And, in this way, they work in favor of the Fed and give meaning to its gradual strategy.

The bull market can wait. In a tremendous week, it went around in circles. Dazed, the Nasdaq finished down 2%. The Dow Jones Transportation and the S&P Small Caps were up 1.4%. As already mentioned, the last will be the first. The popular masses corrected quietly in August and September. Now it is the turn of the big stars, those that shone on the billboard. A healthy economy provides support against the backdrop. The elections and the reaction of the Trump Administration will steal the cameras and attention. While AI takes the exam and adjusts its guidance, balances continue to push profits to new highs. At just over 18 times expected earnings (for the next 12 months), the S&P 500 is trading at par with when President Trump embarked on the crusade against the Day of Liberation. The bull market will not go anywhere until it finishes reconfiguring its GPS, but while the purge settles, it substantially strengthens its valuation. And the AI crusade, perhaps better dosed, is still ahead.

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