Fed Chairman Kevin Warsh Just Said 6 Words That Completely Shifted Investor Expectations

Kevin Warsh has significant plans to overhaul the Federal Reserve's communication policy under his chairmanship. He wants to reduce the amount of forward guidance he provides to market participants, which he thinks will give the Fed clearer signals about real-time economic data and give the Federal Open Market Committee (FOMC) more flexibility in its monetary policy decisions.

When Warsh has something to say, he'll say it. And he made it very clear what his plans are for the Fed in his first press conference as chairman. With just six words, he completely shifted investors' expectations.

Image source: The Federal Reserve.

The overarching focus on the Federal Reserve right now

Warsh took the chair of the Federal Reserve at a difficult time for monetary policy. The war in Iran led the country to block the Strait of Hormuz, sending oil (and other commodity) prices skyrocketing. The knock-on effects on inflation were immediate, with the Consumer Price Index (CPI) spiking in March and climbing higher still in April and May.

The Fed has to decide how to respond to inflation. At a recent conference, Warsh dodged a question about whether the recent bout of inflation is temporary, which could give the market hints about how he'll vote in the next few FOMC meetings. However, he made it clear about how he expects the Federal Reserve to act during his tenure as chair during his first FOMC meeting a few weeks ago.

"This Committee will deliver price stability," the committee published in its official statement. Warsh reiterated those six words in his press conference and has continued to restate that straightforward message in the weeks since.

Warsh hasn't provided specific details on how he expects to deliver price stability, but there are only so many tools in the Federal Reserve's repertoire: It can raise rates or reduce its balance sheet.

Warsh has stated that he wants to reduce the balance sheet, either by selling existing bond holdings or by letting them mature without buying replacements. The net effect would be pressure on long-term bond prices, leading to higher interest rates for those instruments. However, he warned that unwinding the balance sheet will take a long time. At the European Central Bank forum this week, he noted it took 18 years for the Fed to build its balance sheet, so he can't just "bring it down to size" too quickly.

Warsh also noted that he wants "interest rate policy to be the working core for monetary policy," providing a good idea of the main tool he wants to use to deliver price stability.

Market expectations are shifting

While investors were expecting rate cuts heading into the year, they had pretty much given up on that idea before Warsh even took his seat as chairman of the Federal Reserve. But after his hawkish tone at the first FOMC meeting, investor expectations have shifted even further.

Futures traders are now pricing in a greater-than 75% chance of at least one rate hike before the end of the year, up from a 58% chance at the start of June. Those rate hikes could come as soon as September, with most expecting Warsh and the FOMC to stay the course in the upcoming July meeting.

But it's more than just rate hikes where investors have shifted their expectations. Consumers expect Warsh to deliver on his words. Inflation expectations for the next year and next five years dropped in the most recent University of Michigan survey of consumers despite May's CPI numbers coming in even higher than the month before.

Rising interest rates and slower inflation could have a notable impact on the stock market and key indexes like the S&P 500 (^GSPC +0.00%) or Nasdaq Composite (^IXIC 0.80%). Higher interest rates generally lead to lower market valuations as investors demand a higher discount rate for future earnings. However, earnings for consumer-facing companies could benefit as stable prices provide greater consumer confidence. It's a careful balancing act and a lot of it hinges on Warsh's policy lead as Fed chairman.

With the stock market already pricing in substantial earning growth over the next few years, there's not a lot of room for error. Unnecessary or ineffective rate hikes will lead to lower stock prices. But if Warsh can enact prudent monetary policies, it could result in stable pricing for both consumers and investors.