Warsh and Peace: Iran tensions, bond market complicate Fed outlook

• Key insight: The Federal Reserve's preferred economic indicators in recent weeks support the central bank keeping interest rates unchanged, while certain real-time data suggest a rate hike to tamp down inflation might be in order.
• Expert quote: "My suspicion is the chair will find it in his own best interest to describe the committee's reaction function to the market. It's part of the responsibility of the Fed to tell the market what it's thinking, not just what it's doing." —Derek Tang, CEO of Monetary Policy Analytics
• Forward look: The Federal Open Market Committee meets Tuesday and Wednesday, and Fed Chair Kevin Warsh will announce the group's policy decision on Wednesday afternoon.

Is it the best of times or the worst of times for the Fed to hike interest rates? Either way, this week's meeting of the new-look Federal Open Market Committee will give market observers new clues on how the U.S. central bank interprets a mixed bag of economic data.
Based on its core economic indicators — inflation and unemployment — the Federal Reserve appears on solid footing to keep its benchmark interest rate unchanged. But renewed tensions in the Middle East have bond markets pricing in higher inflation, building the case for rate hike during Wednesday's policy vote.

The committee will have to grapple with which sets of data serve as more reliable indicators of where the economy is heading. For Fed Chair Kevin Warsh, the challenge will be conveying to the public how the monetary policy-setting committee reached their conclusion in this meeting without setting an unwanted precedent for future meetings.

"My suspicion is the chair will find it in his own best interest to describe the committee's reaction function to the market," said Derek Tang, CEO of Monetary Policy Analytics. "It's part of the responsibility of the Fed to tell the market what it's thinking, not just what it's doing."

Other observers expect Warsh to give scant details about the specific factors that will have fed into the FOMC's decision. Jai Kedia, a fellow at the Cato Institute's Center for Monetary and Financial Alternatives, said it is logical for Warsh to avoid voicing his own opinions on the Fed's framework while he awaits the findings from his externally commissioned policy review task forces.

"He doesn't want to bias the task forces one way or another," Kedia said of Warsh. "Once they submit their reports, it will be fair to ask about the objectives they outlined and how the Fed intends on meeting them, but it would seem odd if he were to provide his own opinion on those topics ahead of time."

After voting to hold interest rates steady during its meeting last month, the FOMC received two economic reports that seemed to bolster the odds that the federal funds rate would remain unchanged for a fifth straight meeting. 

First came the Bureau of Labor Statistics' jobs report on July 2. The economy added fewer workers than expected in June and the agency revised down its estimates from April and May, but the report showed continued workforce growth and the unemployment rate fell slightly from 4.3% to 4.2%. Market expectations for a rate hike in July, which climbed as high as 38% after the June FOMC meeting, plummeted to 18% on the news, according to the CME Group's FedWatch tool. 

Then came the BLS' consumer price index report, which showed an annualized inflation reading of 3.5% from June, down from 4.2% in May, the first month-to-month decline since January. Interest rate hike expectations, which had crept up to more than 41% by July 13, quickly tumbled to less than 12%. 

Together, the reports indicated that the economy was continuing to grow and prices were quickly normalizing in the wake of a détente between the U.S. and Iran. But those peace talks broke down last week, resulting in attacks on commercial ships in the Persian Gulf and an attempted blockade of vessels attempting to exit the Red Sea. Those attacks pushed Brent crude oil prices over $100 per barrel from $72 at the beginning of the month. At the same time, 10-year Treasury yields hit 4.7%, the highest level since early 2025. 

While oil prices and long-term yields both came down slightly at the beginning of the week, the prospect of a prolonged conflict and persistently higher commodities prices raises inflationary pressure in the U.S. economy for the foreseeable future, Tang said.

"We dealt well with the initial shock in February, March and April, but there's no guarantee that we can handle that kind of shock again," Tang said. "We were able to fare well because we were drawing down reserves and consumers were propped up by things like tax returns. We don't have those safety nets now."

Thus far, Warsh has sent mixed signals about how he thinks energy prices should be factored into the Fed's inflation framework. During his nomination hearing in front of the Senate Banking Committee, he said the Fed should not feel the need to focus on core inflation readings — those that factor out food and energy — because data collection methods have improved over the years. 

"We'd exclude food and energy because it was sort of a rough swag as to what was going on," Warsh said. "We don't have to do a rough swag anymore."

At the same time, Warsh said he preferred to use trimmed average readings of inflation, which filter out all outlier price changes. 

"What I'm most interested in is what's the underlying inflation rate," he said. "Not what's the one-time change in prices because of a change in geopolitics or a change in beef [prices], but what's the underlying generalized change in prices in the economy."

Data sources and inflation are two of the five topics assigned to the external task forces Warsh has assembled to evaluate the Fed's monetary policy framework. Those groups are expected to spend the next several months reviewing the central bank's current approach and deliver recommendations by the end of the year.

In the meantime, banks and other financial institutions have two choices: try to glean the Fed's reaction function based on limited guidance or simply run with their own economic analyses. Warsh has said he would prefer the latter. 

Other central bank leaders around the world have also embraced this approach, shifting to less forward guidance and encouraging firms to do their own "homework." Yet, there are always risks that banks make the wrong bet on interest rates. Michael Redmond, a U.S. policy economist with Medley Global Partners, said such a disconnect is more likely to occur when the private sector does not understand the Fed's underlying guiding principles.

"If they do hike, what would prevent the market from pricing in three more hikes if they think the Fed is targeting a specific set of rules and [is] therefore likely to aggressively hike interest rates from here? Or what if they think policy is being tied to the commodity cycle?" Redmond said. "It can become a volatile, crazy environment if the Fed abandons the metrics that guided them before, as flawed as they might have been."

Kedia, an advocate of rules-based approach to monetary policy, said it is important for the market to understand the Fed's framework — eventually. For now, he said, it is best for the Fed to hash out what that framework should be and allow financial institutions to do their own modeling on the economic outlook.

Kedia noted that market interest rates — ranging from Treasury yields to interest rates on mortgages, credit cards and auto loans — are already moving independent of the federal funds rate and provide a better indication of what lies ahead. 

"What banks should be doing is seeking out the clearest sign of what is happening in the economy," he said. "To me that's market rates — not what the Fed is saying."