Hike or hold: Fed chief Warsh faces another tough choice on rate decision

THE signs are there that the US Federal Reserve could spring a big surprise soon, and it could happen as soon as this week. Fed chief Kevin Warsh has indicated that he is ready to make a major decision without giving the market any advance notice.

The proof of that pudding will come on Wednesday (Oct 28). The markets, however, overwhelmingly anticipate the Fed to take the cautious route of holding interest rates unchanged at their current level of between 3.75 per cent and 4 per cent.

If ever a Fed chair was to defy market expectations, now could be the time. Energy inflation is rampant and its transmission to other categories of products and services is becoming increasingly clear. A big reason bond markets are going haywire around the world is a sense that central banks are not acting drastically enough.

Strategists at Bank of America Global Research said that Warsh has a tough choice between a “sea change or a wee change”. Neither is likely to be that well received by the stock market, unfortunately.

September readings of both consumer and wholesale inflation in the US were above economists’ expectations and well above the Fed’s 2 per cent targets. And that was before oil prices hit a five-month high due to rumblings of another round of airstrikes from Israel and the US on Iran.

The conflict is at its loudest since immediately before the war started at the end of February. Iran is reportedly plotting to assassinate US leaders and strike Gulf civilian facilities if the US and Israel continue their war plans. Oil futures are currently at their highest levels since May, with the globally traded Brent futures contract topping US$115 a barrel.

The hot September price data “bolsters the case for an October hike”, said the Bank of America strategists, adding that it also leaves Warsh in a quandary.

“If the Fed hikes, investors might have concerns about overtightening. If the Fed holds, markets could question the Fed’s credibility,” they said.

Even if the Fed doesn’t hike rates, Warsh will have to address the central bank’s inflation-fighting plans. American consumers are fed up with rising prices.

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Diesel prices, the most important measure of the freight cost, have hovered around US$6 a gallon (4.5 litres) in the US for more than two months.

The consensus on Wall Street is that the central bank will leave rates unchanged in October, but continue hiking rates in December. Fed Funds futures markets attribute a 90 to 95 per cent likelihood that the central bank keeps rates unchanged on Wednesday.

The odds of a hike were much higher until the recent stock-market sell-off. Bond traders doubt that the central bank will put further stress on the financial system at a moment when credit worries are already elevated.

There are two related sources of this stress. One is the broad claim made recently by Ken Griffin, head of hedge-fund giant Citadel Securities, that there is a speculative bubble in artificial intelligence stocks.

The other is the fear that smaller AI firms such as cloud-computing company CoreWeave and chipmakers such as Broadcom will never be able to repay the billions of dollars they have borrowed to fund the AI build-out.

“These are the companies supplying the infrastructure behind the AI revolution, and their leadership has helped fuel the broader market rally,” said Jay Woods, chief market strategist at brokerage Freedom Capital Markets.

A rate hike or an unconvincing hold would be a shock to these over-extended AI companies – and, hence, to the broad market – because it would drive up Treasury yields.

That said, Warsh has a difficult choice to make this week. But perhaps what’s even tougher for him is that he has to convince everyone that he has made the right one.