The Fed's Rug Pull is 24 Hours Away.

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Video Summary

The Federal Reserve is widely expected to enact a rate hike this week, driven by persistent inflationary pressures and a surprisingly resilient labor market. Despite the common critique that interest rate hikes cannot physically extract more oil from the ground, internal research from the Richmond Fed suggests that central banks must act decisively against oil-driven supply shocks to prevent inflation expectations from becoming unanchored.

With core and 'super core' inflation metrics remaining elevated, the pressure is mounting on Fed Chair Kevin Warsh to prove his independence. A failure to hike could trigger a catastrophic surge in 10-year Treasury yields, potentially destabilizing markets. The decision serves as a critical test for the Fed's dual mandate, balancing the necessity of cooling an overheated economy against the political fallout of defying expectations.

Short Highlights

Evidence supporting a near-certain interest rate hike:
- A 92% to 94% probability priced into markets.
- Strong employment data with an increasing average work week.
- Rising input and selling price pressures reported by firms.
- 'Super core' inflation reaching a four-month high.
- Richmond Fed research arguing against ignoring oil-driven supply shocks.
- The risk of 10-year Treasury yields skyrocketing if the Fed holds.
- The necessity for Chair Kevin Warsh to demonstrate policy independence.

Key Details

Labor Market Strength [01:23]

The Empire Manufacturing Survey indicates that employment is increasing at a solid pace, with the average work week rising considerably.
This strengthening labor market creates a risk of wage-price inflation as companies raise wages to retain workers.
The more the work week rises, the more risk there is that we get, we end up seeing more wage price inflation, which is where wages actually rise, because people are needed more at work, and rightfully so.

Inflationary Pressures [03:00]

ADP data shows a bullish stabilization in the labor market since July and August, reducing the Fed's concern about employment weakness.
Inflation expectations for the next five years have been rising since the last meeting, signaling that the Fed needs to take action.
If they don't hike, my expectation is the 10-year goes to the moon.

The Oil Shock Dilemma [05:07]

An oil shock impacts the economy directly through gas prices and indirectly by forcing firms to raise prices to cover increased operational costs.
Super core inflation is currently running at an annualized rate of 6.1%, suggesting that oil prices are flowing through to the broader economy.
It takes three to six months to reach a peak response by firms in core inflation.

Richmond Fed Policy Shift [07:22]

A recent piece from the Richmond Fed challenges the conventional wisdom that central banks should ignore supply shocks like oil price spikes.
The research suggests that because the Fed has an employment mandate alongside an inflation mandate, it must act to prevent inflation expectations from unanchoring.
To me, that view is really outdated. I don't think that's how central banks should behave in the face of a major oil shock.

Political Stakes for Kevin Warsh [09:05]

Despite being handpicked by Donald Trump, it is widely expected that Kevin Warsh will lead the committee to raise rates.
The White House has indicated it will support the Fed's decision, even if it contradicts previous political rhetoric.
Warsh criticized the Fed for moving too slowly to cut one year ago, but there's a time for a bird to change his feathers.

Market Consequences of Inaction [10:25]

If the Fed fails to hike, the 10-year Treasury yield could potentially jump to 5.15%.
Holding rates steady would render the Chairman's previous warnings meaningless and signal a loss of control over the committee.
Holding now would leave the chairman as a person whose warnings cost nothing to ignore.

The Path Forward [11:30]

The focus for investors should not just be the hike itself, but the language used by Warsh to frame the future of the cycle.
A hawkish tone indicating that this hike catches the Fed up to data would be viewed as bullish, whereas signaling a long cycle of hikes would be negative.
I'm very curious to see what he says. That's all going to be what it comes down to.