Markets Hold Firm as Inflation Risks Build

Markets continue to hold up remarkably well as we move through the traditionally difficult second half of August, but the risks beneath the surface have shifted. Commodity prices are rising, money growth remains stronger than I would like, and long-term interest rates are again testing important levels. All of this makes this week’s Jackson Hole meeting particularly important, not because the Federal Reserve needs to change policy, but because Chairman Warsh needs to explain more clearly what will drive policy going forward.

I was not enthusiastic about Treasury Secretary Bessent’s suggestion that the Treasury could influence the slope of the yield curve by changing the relative supply of short- and long-term securities. I call this the “Bessent twist,” and I do not think it is a good idea. The irony is that Warsh emphasized allowing markets to send their own signals, while the Treasury appears interested in deliberately altering those signals. Long-term rates incorporate expectations for inflation, economic growth, future Fed policy, deficits and risk premiums. The Treasury should be very cautious about trying to manage that market because attempting to influence long rates and failing could damage credibility.

The yield curve itself is not particularly abnormal. The spread between the 10-year Treasury and the federal funds rate is close to its long-run historical average. The 30-year Treasury yield has broken above its previous high, generating headlines, while the 10-year has approached but did not exceed its prior peak. Investors should remember that the 30-year mortgage is primarily priced off the 10-year Treasury, not the 30-year bond. I continue to believe 5% on the 10-year is the important psychological threshold where financial markets become increasingly sensitive.

The more important question is whether the economic data justify higher rates. Last week I expressed some optimism that money supply growth might be moderating, but the latest weekly deposit data came out stronger again. At the same time, the Bloomberg Commodity Index is now less than 3% from its all-time high, while oil has risen following increased economic pressure on Iran. The upcoming PCE report should still be relatively benign. Inflation expectations remain anchored and housing inflation continues to moderate, but if commodity prices and money growth remain firm, the economic case for another rate increase will become stronger.

Nevertheless, I would be very surprised to see the Fed raise rates before the November election. The economic cost of waiting until December to move 25 basis points, if a hike ultimately proves necessary, is quite small. With the election approaching and President Trump having recently appointed Warsh, the political hurdle for pre-election tightening is extremely high. My base case remains that the Fed holds rates steady through the election and reassesses afterward.

That makes communication especially important. My criticism of Warsh’s last press conference was not that he refused to provide forward guidance. A central bank does not need to tell markets what it will do months in advance, but it does need to explain what variables it is watching. Jackson Hole gives Warsh an opportunity to clarify that reaction function. If he does not, it will be disappointing but not devastating. The September FOMC meeting, which includes the Summary of Economic Projections, will provide a second and ultimately more important opportunity.

The economy, meanwhile, remains resilient. Current estimates suggest third-quarter real GDP growth around 2.5%, even with relatively weak payroll growth. That is a healthy combination, and one reason equities have absorbed the rise in bond yields reasonably well. Geopolitical risks remain important, particularly the administration’s increasing economic pressure on Iran and the potential use of secondary sanctions. I also remain concerned that Iran could increase its targeting of shipping through the Strait of Hormuz as the U.S. election approaches. A significant disruption to oil flows would immediately complicate the Fed’s inflation outlook.

For now, equities continue to demonstrate impressive resilience. But rising commodities and continued money growth mean the Fed cannot declare victory on inflation. Jackson Hole does not need to deliver a policy surprise. What markets need from Warsh is something simpler: a clearer explanation of the signals that will determine what the Fed does next.