Fed Keeps Rates Unchanged at July Meeting as Wall Street Interprets Warsh’s Views

TradingKey - The Federal Reserve kept interest rates unchanged at its July meeting, but Fed Chairman Kevin Warsh's remarks at the press conference triggered far more controversy than the rate decision itself.

On July 29, Eastern Time, the Federal Reserve announced it would maintain the target range for the federal funds rate at 3.50% to 3.75%, holding steady for the fifth consecutive meeting. The policy statement changed little compared to June, but the voting results showed growing divergence within the Fed over inflation risks.

Cleveland Fed President Beth Hammack, Minneapolis Fed President Neel Kashkari, and Dallas Fed President Lorie Logan all advocated for a 25-basis-point rate hike, with the final resolution passing 9-3. Three dissenting votes in a single meeting is uncommon, indicating that some officials believe the risk of the Fed continuing to wait is rising in the face of still-elevated inflation.

However, drawing more attention than the rate decision itself was Warsh's stance on rising bond yields. Instead of trying to soothe the rise in long-term rates, he believed that the market had proactively tightened financial conditions, doing part of the work for the Fed.

Wall Street analysis suggests that Warsh seems to be developing a new policy approach: when the bond market has already proactively pushed up borrowing costs, the Fed may not necessarily need to raise the policy rate immediately.

Warsh Signals Market Rates Are Replacing Fed Hikes

For the past few years, the Federal Reserve has relied on the policy rate to regulate financial conditions, but the message from this meeting was somewhat different.

Warsh repeatedly emphasized that the recent rapid rise in US Treasury yields has in itself raised borrowing costs, exerting a dampening effect on real estate, corporate loans, and overall economic activity. Therefore, under these circumstances, the Fed may not need to continue raising the policy rate to achieve the same objective.

In other words, if the bond market can actively push up long-term borrowing costs, the Fed can reduce the necessity of actively raising rates.

This view quickly became the focus of discussion on Wall Street.

Goldman Sachs ( GS ), Barclays ( BCS ), and Nomura Securities have all noticed this change. Goldman Sachs believes that Warsh has actually endorsed the logic of "market interest rates substituting for policy rate hikes."

Barclays pointed out that the Fed's internal models also show that when the term premium continues to rise, higher long-term rates can produce a tightening effect similar to a rate hike.

Nomura believes that Warsh prefers to let the market adjust interest rates on its own based on economic data, rather than having the central bank continuously provide explicit guidance. This approach could reduce the Fed's direct intervention in market pricing, but it would also make the future policy path harder to predict.

The market quickly expressed its understanding through pricing.

Following the release of the decision, the US Treasury market showed clear divergence, with the 2-year Treasury yield falling back while the 10-year and 30-year yields rose rapidly, with the 30-year yield briefly breaking above 5.20%, hitting its highest level since 2007.

This "short end down, long end up" trend significantly steepened the yield curve, marking one of the most dramatic curve adjustments following a Fed meeting in recent years.

Most Institutions See Warsh as Dovish as Wall Street Weighs In

While the overall meeting statement was relatively neutral, Wall Street generally believed that Warsh's remarks at the press conference leaned closer to dovish.

Goldman Sachs analyst David Mericle pointed out that before the meeting, market divergence over whether the Fed would raise interest rates was at a level rarely seen in nearly 30 years, but the final decision fell significantly short of the tightening expectations of some investors.

Warsh did not clearly lay the groundwork for the next rate hike; instead, he repeatedly emphasized that rising long-term market interest rates have already tightened financial conditions, which could to some extent substitute for Fed rate hikes.

When pressed by reporters on whether rate hikes are the primary means of tackling high inflation, Warsh only stated that rate hikes could be one of the policy tools, but without specifying their importance or the conditions for their use. He also mentioned that the Fed is reassessing its monetary policy framework, balance sheet, and communication methods, but provided no clear direction for adjustments.

Such vague phrasing makes it difficult for investors to gauge the Fed's future policy response. On one hand, Warsh repeatedly emphasized his determination to bring inflation down to 2%; on the other, he suggested that the bond market has already done some of the tightening for the Fed.

It remains unclear how the Fed will strike a balance between controlling inflation and preventing the economy from coming under pressure.

Financial writer Greg Ip believes that Warsh's explanation of bond yields is contradictory. When yields fell previously, Warsh viewed it as a signal of improving inflation prospects, but now that yields are rising, he believes that higher borrowing costs will help curb inflation.

Without a stable policy framework, it is difficult for the market to judge whether changes in yields represent strong economic fundamentals or reflect investor concerns about inflation and the Fed's credibility.

Economist Peter Schiff's view is more pessimistic. He believes that although Warsh emphasizes the 2% inflation target, he is unwilling to bear the pressure that rate hikes could exert on the economy and the market. If the Fed delays taking action, long-term yields and inflation expectations could still rise on their own, ultimately producing a similar or even greater tightening effect on the economy.

Goldman Sachs estimates that if core inflation continues to slow over the coming months, the Fed may hold interest rates steady for the remainder of 2026.

Robin Brooks, a senior fellow at the Brookings Institution, also believes that Warsh did not balance the decision not to raise rates with tougher rhetoric, overall sending a fairly clear dovish signal.

Following the meeting, the interest rate futures market's expectations of a September rate hike fell from near-unit pricing before the meeting to about 60%, indicating that investors believe the certainty of a Fed rate hike in the near term has declined.

Institutions Shift Focus to Long-Term Rates and Policy Credibility

A decline in near-term rate hike expectations does not imply that the market is more optimistic about the long-term outlook. Several institutions have begun shifting their focus to long-term US Treasury yields and the Federal Reserve's policy credibility.

Barclays believes that under Warsh's current policy approach, the bar for a September rate hike has been raised, but the risk of long-term Treasury yields continuing to rise has also increased. As long as the Fed continues to rely on the bond market to tighten financial conditions, long-end rates may remain elevated.

Nomura warns that if inflation strengthens again and the Fed remains slow to act, long-term inflation expectations could rise further. Bank of America also believes that once the market begins to question the Fed's resolve to achieve its 2% inflation target, the central bank may be forced to adopt more aggressive tightening measures in the future.

The view of Ed Yardeni, president of Yardeni Research, is even more direct. He believes the Fed may need to raise short-term policy rates to anchor inflation expectations, thereby easing the upward pressure on long-term rates. If policy rhetoric leans hawkish but lacks concrete action, it could instead damage the Fed's credibility, prompting investors to demand higher long-term inflation and risk premiums.

Therefore, while Warsh's current avoidance of rate hikes reduces short-term policy pressure, it may increase the risks of rising long-term rates and future policy adjustments.