What the Fed's Latest Warning to Wall Street Could Mean for Investors

Don't fight the Fed.

It's a simple axiom that most seasoned investors have learned over years of investing and generally abide by.

Why? When the Federal Reserve loosens monetary policy by lowering interest rates, it's a tailwind for the entire stock market because companies' interest expenses fall, leaving more money to invest in equipment and people to increase their top and bottom lines. In addition, it also tends to make it easier for consumers to finance purchases, which drives consumption higher.

And all of those factors support positive stock market returns.

By contrast, when the Fed is tightening policy by raising its benchmark interest rate, borrowing money becomes more expensive for both companies and consumers, which can prove a real headwind for stocks.

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In late July, the Fed met for its second meeting under new Chair Kevin Warsh. And while Warsh and his colleagues on the Federal Open Market Committee (FOMC) -- the Fed's rate-setting committee -- didn't change the target range for the federal funds rate, in the press conference that followed the statement, Warsh issued a warning to Wall Street that investors should take seriously.

Warsh says there's no soft target

"There is no soft inflation target, there is no soft implicit target -- not on this Committee's watch. There is only a target, and it is 2 percent," Walsh said.

What exactly was he talking about?

Well, a little bit of Fed history is in order here. Back in 2020, when Jerome Powell was Fed chair, the Fed adopted a more flexible approach toward achieving its 2% annual inflation goal. It was called "average inflation targeting," and the idea was that the Fed could tolerate inflation above its 2% target for a period of time to offset periods when inflation was below it.

Warsh's recent statement suggests that the Fed is dropping this approach in favor of a firm 2% target.

And right now, inflation is very much above the Fed's target. The Personal Consumption Expenditures Price Index is the Fed's preferred inflation gauge. And the latest PCE index reading, for June, showed that inflation rose 3.7% over the past year. Even when volatile food and energy prices were excluded, the PCE index increased 3.3%.

To be fair, the PCE index fell slightly in June from the May reading, but not enough to get it back to the Fed's 2% annual target.

The next release of PCE data is this Wednesday, Aug. 26. The next two-day FOMC meeting is on Sept. 15-16, with a policy statement and press conference the afternoon of the 16th.

If this Wednesday's inflation data doesn't show meaningful progress toward the 2% target, I believe the Fed will hike its interest rate by a quarter percentage point at the September meeting. And in fact, at the July FOMC meeting, three Fed officials dissented from the statement and called for a quarter-point hike. Others, and possibly Warsh himself, will follow their lead if this Wednesday's data suggests they should.

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