Regime change at the Fed
Looks like new Chair Warsh might be 'independent' after all.
Bottom line
In Kevin Warsh’s first policy meeting as Chair of the Federal Reserve yesterday, the Federal Open Market Committee (FOMC) voted unanimously to leave interest rates in a range of 3.50-3.75%. That was widely expected. But the updated Summary of Economic Projections (SEP) showed that the members on average increased their inflation expectations for 2026. Their new forecast of the core Personal Consumption Expectations (PCE) index, which strips out volatile elements like food and energy prices, rose from 2.7% year-over-year (y/y) in the March SEP to 3.3%. The projections are anonymous, but the meeting’s statement referenced the Middle East conflict, so we can safely assume the policymakers based the increase on the higher energy prices of the last four months. Core PCE sat at 3.3% y/y in April 2026.
The expectations of the policy rate — the dot plot — also saw a sharp shift. Notably, Warsh did not contribute his own forecasts, demonstrating his long-held disdain for it. But half of the participants forecasted no change in interest rates this year and the other half expects at least one quarter-point hike later this year, with six of these projecting at least two.
“The Committee will deliver price stability,” Warsh said during his post-meeting press conference with the financial media. That must have come as something of a pleasant surprise — if not an outright shock — to the US Senators who voted against his confirmation last month, due to their concern about his independence from President Trump, who has been extremely vocal that rates should fall.
Financial markets responded poorly Two-year Treasury yields surged to 4.20% yesterday, the highest level since February 2025. With the upper band of the fed funds target rate at 3.75%, the bond market is now pricing in a quarter-point hike at the October FOMC meeting. That triggered a risk-off move for stocks, with all major equity indices trading down by more than 1%. Stocks and bonds are regaining some of that lost ground today, ahead of the long Juneteenth holiday weekend.
We’ve got a task force for that Rather than rush into the much needed and long-awaited regime change Warsh has promised, he took a measured approach. During his first press conference, Warsh unveiled the creation of five task forces to review best practices at the Fed. His plan is to help the central bank achieve its longer-term goal of 2% core inflation, a target that has eluded the Fed through its monetary policy missteps over the last five years.
- Communication The Warsh Fed eliminated forward guidance yesterday, and the post-meeting statement was considerably shorter than typical. But what about the press conferences, dot plots and the constant flow of speeches – sometimes contradictory – delivered by FOMC members of the Fed between policy-setting meetings?
- Balance sheet It sits at $6.7 trillion now, and Warsh wants to shrink it significantly. He has mentioned eliminating mortgage-backed securities and reducing the amount of Treasury holdings. But what’s the right timing and level, and what might be the impact on economic growth, inflation and interest rates?
- Use and reliance on existing data sources Is the Fed using the right metrics to reach its monetary policy decisions, and is the data accurately measuring the economy?
- Productivity/AI and jobs Productivity has risen 2.8% over the past four quarters (versus 2% over the past half century) due to robust corporate spending and the labor market is trending better, according to Warsh. Is this link sustainable, as former Chair Alan Greenspan believed?
- The Fed’s inflation framework Is 2% y/y core PCE the correct inflation touchstone for the Fed to target, rather than, for example, the Dallas Fed’s trimmed mean measure?
Other changes to the SEP The central bank reduced its expectations for GDP growth and unemployment this year but increased its estimates for core PCE inflation and interest rates.
GDP growth lower now and higher later The Fed reduced its estimate from 2.4% in March to 2.2% in June, compared with 2.1% in 2025. We are forecasting 2.5% in 2026. It left its 2027 forecast unchanged at 2.3%; we are forecasting 3.0%. The Fed also raised its 2028 forecast from 2.1% to 2.2%.
Labor market strengthens Policymakers reduced their estimate for the unemployment rate (U-3) from 4.4% in March to 4.3%, which is in line with U-3 the past three months through May. Nonfarm payrolls have grown an average of 188,000 jobs over the same period, compared with an average of only 10,000 jobs per month during 2025. They left U-3 estimates unchanged at 4.3% in 2027 and 4.2% in 2028.
Inflation surged The Fed increased its estimate for core PCE inflation from 2.7% y/y in March to 3.3% in 2026, compared with 3.0% in 2025. It hit 3.3% y/y in April, up from a four-year low of 2.6% in April 2025 and 3.0% in February 2026. In 2027, the central bank increased its core PCE target from 2.2% in March to 2.5% in June. Its 2028 estimate inched up from 2.0% to 2.1%.
Interest-rate bias moves higher In its March SEP, the Fed was expecting one more quarter-point cut during 2026 and another cut in 2027. But given the Iran war and the temporary surge in energy prices and inflation, the Fed has shifted gears and is now expecting a quarter-point interest rate hike before year-end 2026, followed by one cut in each of 2027 and 2028.
It’s still all about Iran Crude oil prices (West Texas Intermediate, or WTI) more than doubled from a five-year low of $55 per barrel in early January 2026 to $120 on March 9, before plunging by 38% to $74 today. Lagging gas prices soared 63% from $2.80 per gallon in January 2026 to a peak of $4.56 on May 20, before declining by 12% to $4.00.
If the recent Iranian peace deal, signed by President Trump earlier today, manages to hold and the Strait of Hormuz opens, Middle Eastern oil should soon flow freely. It follows that energy prices should decline. In our view, that would allow the Fed to look through the temporary energy-related spike in inflation and stand pat on interest rates through year-end.
Read more about our views and positioning at Capital Markets.