Warsh's hawkish stance puts Fed credibility to the test

This particular Fed decision was never going to be solely about another 25 bps rate hike.

For Kevin Warsh, the moment was also about defining the principles of his Fed, even at this early stage of his chairmanship.

After months of persistent inflation, the central bank finally moved to act, with increasingly uncomfortable bond market moves arguably also pushing policymakers into a corner.

The vote to raise rates to 3.75% - 4.00% was ultimately unanimous, but the real significance lay in the details surrounding the decision.

The latest dot plot projections, in particular, reveal that 16 of 18 policymakers anticipate at least one more hike before the year ends. That is hardly the kind of message from a central bank looking to simply wrap things up.

Warsh reinforced that sentiment in his press conference, where he argued that describing financial conditions as restrictive was a stretch. In essence, the Fed believes a single 25 bps move does not slam the brakes on the economy.

Staying true to his style, he resisted the notion of forward guidance. While he appeared prepared to hike again, he stopped short of making any firm commitments. Still, he came off as more hawkish, even as he cleverly played his political hand by declining to cite the US fiscal deficit as a primary driver of higher bond yields.

That was a delicate balancing act, yet Warsh managed to sound hawkish without locking the Fed into a set rate trajectory. More importantly, he provided a credible response to doubts about the Fed's commitment on inflation without giving too much ground.

That matters because credibility does not come from talking tough just for show. It is about convincing markets that when the Fed calls inflation unacceptable, policy will back up those words.

President Trump was clearly displeased with the outcome, though his criticism still did not go so far as to attack Warsh directly:

"Interest ‌Rates in the United States should be 1%, or less, because we are the Best Credit in the World - BY FAR. I talked to Kevin.. And I said you might ⁠as well vote with the board because it's not going to matter. The board is very hostile. They're very political. They're doing the wrong thing."

At this point, the Fed cannot keep insisting that price stability is paramount while ignoring persistent inflation as if it were someone else's concern. Eventually, policy must reflect that reality.

Yesterday's move is at least a step in that direction.

Markets certainly took notice. The dollar firmed up, 2-year Treasury yields climbed, and rate futures now price in roughly a 90% chance of another hike before the year is out.

The market reaction may not please everyone, but it is arguably preferable to the bond market lashing out if the Fed had chosen a different course. Yet that is almost beside the point.

Warsh has consistently argued that the Fed must restore price stability. After yesterday's decision, markets now have proof that his words carry real weight.