Warsh's Fed credibility at stake, but markets see 91% rate hike odds

It's decision day at the Federal Reserve, with the announcement due at 2 pm ET and Chair Kevin Warsh's press conference set to begin half an hour later.

This could be one for the history books. It marks Warsh's first major test of political backbone and independence. His surprisingly hawkish stance at Jackson Hole in August has led traders to assign a 91% probability of a rate increase, with 90 basis points of tightening anticipated over the coming year. Those odds have climbed in recent weeks as US economic data outperformed and inflation readings came in a touch hot. On Wednesday, that trend was reinforced by a retail sales report showing the closely monitored control group of core sales up 1.4% versus the 0.4% expected.

Given all that, market participants and analysts alike have largely concluded he will raise rates.

The wildcard, as ever, is Trump. The President, an outspoken dove who favors rate cuts, personally selected Warsh and several Fed Board members to pursue that objective. Warsh played up that angle during his confirmation, but since taking the helm he has struck a different tone, criticizing previous Fed leadership and vowing to bring inflation back to 2%.

But talk is cheap. Trump once tried to launch a criminal investigation into then-Chair Powell as a political vendetta for refusing to follow the President's wishes. Now Warsh must defy him at a crucial moment ahead of the midterms, with Republicans trailing in polls and facing the prospect of losing both chambers of Congress.

Polymarket bettors are giving a 47% chance that Trump will publicly attack Warsh by Sept 30.

So regardless of today's outcome, we're likely to see either central bank drama or political drama.

For markets, political turmoil is nothing new. Warsh is probably shielded on that front due to his father-in-law, Ronald Lauder, a major Trump supporter, donor, and friend. Still, with Trump, certainty is elusive, and Warsh shouldn't expect a smooth ride if he follows the market's current pricing.

The irony is that Trump largely has himself to blame for rate hikes, as I suspect the Fed would be holding steady were it not for the energy price surge caused by the Iran war.

On the market front, a hike today alone won't cause major ripples, but the commentary that follows could. I'd anticipate another noncommittal statement, but Warsh will face tough questions in the press conference about the path ahead. He'll likely stick to his preference against pre-commitment, which won't be easy. Having framed himself hawkishly at Jackson Hole, he'll need to echo those remarks to avoid sounding dovish. Yet doing so risks coming across overly hawkish and boosting the odds of another hike in October.

His key message at Jackson Hole:

The thing about market measures of inflation expectations in economic history is that they tend to look strong and durable until they don't. Those expectations are not pushed around easily, and right now they are well anchored. But they must be closely minded. It's the Fed's job to make sure that inflation expectations do not get unanchored.

There is one signal nobody can miss: The responsibility for 65 months of sustained, elevated inflation sits squarely with the central bank. And that is where it belongs.

Here is my standard: We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do. That's our job . . . our mandate . . . and our charge to keep.

So what happens if Warsh defies the market and holds rates?

That would likely be a watershed moment for central banking. The Fed remains one of the few US institutions with independent credibility. The 2% inflation target hasn't been met lately, but there's still widespread belief that officials are doing their best. If they don't hike today, there's a significant risk of losing the long end of the bond curve and unsettling inflation expectations.

US 10-year yields reached 5.04% this week, the highest since 2007. The fiscal situation is spiraling, and if monetary policy is seen as politically compromised, the dollar's status could suffer too. A rate hold would likely trigger massive gold buying — my first guess for most traders' initial move. The dollar might slide, but there's the risk of a negative feedback loop with bonds that could spur a short-term flight to dollar safety, especially against EM and commodity currencies.

I'd rather avoid that path, but for traders, today is a good day to be prepared for anything.