United Front--Warsh's "three-step approach", the goal is to "restart rate cuts"

Core thesis: There are significant divergences in policy stances within the Fed. After Warsh takes office, how to eliminate opposition and unify the front becomes the core focus for the second half of the year. Step one, July: personnel appointments, working group appointments, counterbalancing the committee; Step two, Q3: framework adjustment, shifting from demand-side to supply-side, productivity and wages become core; Step three, Q4: stance shift: with the groundwork laid in the first two steps, the Fed turns dovish, and rate cut trades restart. Liquidity improvement can be expected, with Treasuries, gold, and tech narratives relatively favorable, but short-term volatility should be guarded against.

In the second half of the year, Warsh's core task is to complete the unification of the Fed's front, planned in three steps:

(1) Personnel appointments: July, working group personnel appointments, counterbalancing the committee

Warsh faces challenges such as shallow roots internally, doubts about independence, and divergent stances. Therefore, he chooses to "rebuild a team," establish a working group, and grant it core policy status. Subsequently, the working group will assume part of the task of guiding market expectations.

(2) Framework adjustment: Q3, shifting from demand-side to supply-side, productivity and wages become core

Traditional employment and inflation indicators have large short-term fluctuations, making consensus difficult. The AI revolution offers Warsh an opportunity to introduce a new supply-side framework, helping him steer the Fed's stance toward convergence.

What does the new framework look like?

(1) Short term: Rely on productivity growth to control inflation, increasing easing room. Case study: 1995-1998, despite strong wage growth, robust economy, and fiscal surplus, labor productivity growth trended upward while inflation fell. The wage-price linkage was broken by productivity gains, and the Fed cut rates. In 1999, the situation reversed; labor productivity growth appeared to peak, and Greenspan worried about tight labor markets, competition for labor resources in new productivity sectors, and rising wages, leading to a rate hike.

(2) Medium to long term: Higher trend productivity growth requires a higher real interest rate, increasing pressure for rate hikes.

(3) Stance shift: Q4, with the groundwork of the first two steps, the Fed turns dovish, and rate cut trades restart. Currently, labor productivity growth is climbing, wage growth is declining, the tech sector is laying off workers, and the labor market is not tight—essentially the mirror image of 1999. If employment and CPI provide moderate support, the working group's final conclusions will likely help the Fed's stance turn dovish, and rate hike trades recede.

Market implications: Liquidity improvement can be expected, with Treasuries, gold, and tech narratives relatively favorable. However, the new framework takes time. In the short term, high rates, a strong dollar, tech concerns, and the midterm elections suppress, so caution against volatility in Q3.

Main Text

The divergence in policy stances among Fed officials is extremely significant. After Warsh takes office, how to eliminate opposition and unify the front becomes the core focus for the second half of the year.

We judge that Warsh's core work in the second half of the year is to complete the unification of the Fed's front, planned in three steps: First, ① personnel appointments; then, ② framework adjustment; finally, ③ stance shift.

(1) Step One, Personnel Appointments: July, making appointments to the working group, counterbalancing the committee

The environment Warsh currently faces within the Fed is relatively complex. In the process of communicating and coordinating with other committee members, there are at least three major difficulties.

First, there is considerable controversy over the Fed's independence. Taking office during a sensitive period of the Trump administration and being noncommittal about Trump's previous interventions in the Fed, his political stance may be questioned by other members.

Second, Warsh has been away from the Fed for a long time, has not been within the government system in recent years, and has limited connections with Fed members and other officials.

Third, the June dot plot shows huge differences in stances among members, making reconciliation inherently difficult.

Therefore, Warsh chooses to "rebuild the team," establish a research working group, and give it important policy status, which helps counterbalance the committee and compete for discourse power. The working group's help to Warsh is reflected in at least two dimensions:

First, by canceling forward guidance and reducing market communication, subsequent policy judgments may heavily rely on the working group's research conclusions. The market may pay more attention to the working group's statements in the future, and the importance of members' speeches may decline accordingly.

Second, it is difficult for Warsh to persuade members in the short term, but he has relatively more room to intervene in the personnel arrangements and research direction of the working group.

(2) Step Two, Framework Adjustment: Q3, from demand-side to supply-side, productivity and wages become core

Currently, employment and inflation data have large short-term fluctuations, and members have differing interpretations, making it difficult to form a unified consensus. Warsh may guide stances toward convergence by introducing a new framework. Discussing monetary policy within the traditional framework puts Warsh at a disadvantage given the huge internal differences within the committee.

The AI technology revolution gives Warsh an opportunity to adjust the framework. He has repeatedly mentioned productivity improvements, and the future framework focus may shift to the supply side. This new framework has at least two different implications: On one hand, Fed policy needs to ensure the ultimate success of the technological revolution and the realization of productivity gains.

On the other hand, inflation influencing factors are not limited to the demand side; the supply side will also play a significant role. Although Warsh emphasizes the 2% inflation target, measures may not be limited to rate hikes (demand-side thinking, sacrificing growth for inflation), but may also include easing (supply-side thinking, boosting productivity to hedge against inflation).

So, what exactly does Warsh's supply-side framework look like? It can be divided into short-term and long-term dimensions:

(1) Short term: The core may be whether labor productivity growth can offset wage increases. If the former trend is upward, expanded product output suppresses prices, giving the Fed more easing room. Conversely, if not, there is upside risk to inflation, requiring the Fed to tighten.

Historical data shows that during periods of rising productivity, U.S. CPI growth tends to be weak. Under this thinking, if productivity is in a rapid growth cycle, the importance of short-term traditional indicators like CPI and unemployment rate declines. Fluctuations in CPI may not be persistent, and a falling unemployment rate does not necessarily mean a significant rise in inflationary pressure.

Take the 1995-1999 Fed policy changes as an example (also during the internet revolution, with significant supply-side impact):

During 1995-1998, the U.S. economy grew strongly, the fiscal budget was in surplus, and wage growth continued to rise. However, Greenspan maintained an overall accommodative stance, achieving a cumulative 125bp rate cut. Aside from explanations such as the Asian financial crisis disturbance, the persistent rise in supply-side productivity growth may also be a logic, with its slope basically consistent with wage growth. The wage-price linkage was broken by productivity gains, and overall CPI growth actually fell.

Entering 1999, the Fed shifted to rate hikes. At that time, wage growth remained high, but productivity growth peaked and declined, and the logic no longer held.

In a speech in May 1999, Greenspan elaborated on related thinking, pointing out three major concerns:

First, the potential remaining labor surplus in the job market was severely insufficient. He stated: "Since the mid-1990s, the number of potential workers has fallen at a rate of a bit under one million annually."

Second, the new productivity sectors generated significant demand for labor, potentially exacerbating upward wage pressures. Data shows that in the second half of the 1990s, employment demand in the internet industry continued to rise, and its employment share trended upward.

Third, he had doubts about whether productivity growth could continue to rise. Although productivity improvements in the 1990s seemed to break the wage-price linkage, the subsequent trajectory was uncertain. He noted: "Forecasting technology has been a daunting exercise" and "The rate of growth of productivity cannot increase indefinitely."

The first two correspond to rising wage growth, the latter to the inability of productivity growth to rise, consistent with the framework we discussed.

(2) Medium to long term: Higher trend productivity growth will require a higher real interest rate to match

Under the expectation of productivity improvement, companies tend to borrow, invest, and hire. However, if future productivity gains are not yet realized and control is improper, current markets may become overly tight, triggering inflation and preventing productivity growth from materializing. Therefore, the Fed needs to moderately raise interest rates to increase society's patience and curb speculative behavior.

This implies that if productivity improvements are indeed realized and sustained, the Fed's medium- to long-term room for rate cuts will decrease.

(3) Step Three, Stance Shift: Q4, after the groundwork of the first two steps, the Fed gradually turns dovish, and rate cut trades restart

As the working group publishes the new framework and conclusions on issues like AI, the Fed's dovish stance will likely gain support, and Warsh completes the unified front.

The logic includes: On one hand, within the new framework, productivity growth is still in a climbing phase, while wage growth has not risen significantly, and the tech sector is not poaching labor resources—all opposite to the situation in 1999, giving the Fed room for flexible policy adjustments.

On the other hand, within the old framework, the persistence of strong nonfarm payroll growth remains controversial, while core CPI is stable month-over-month and the year-over-year may peak and decline. With K-shaped divergence and weak consumption, cost increases from energy and AI have limited pass-through to downstream. Once nonfarm payrolls and CPI decline again in the second half of the year, it will also provide support for an accommodative narrative.

For the market: The formulation of the new framework takes time, and its acceptance takes time. The peak of rate hike trades may be confirmed, but the restart of rate cut trades will not be smooth, especially considering high interest rates, dollar, and stocks, rising tech concerns, approaching midterm elections, and the seasonal weak window. Market volatility in Q3 may still be significant. Subsequently, with liquidity improvement, Treasuries, gold, and tech narratives are relatively favorable.

Source: CITIC Securities

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