The Fed’s credibility hike

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The public view of new Federal Reserve Chair Kevin Warsh from a so-called “sock puppet” to an inflation-fighting hawk has been dramatic

During his contentious confirmation hearings with the Senate Banking Committee last April, Sen. Elizabeth Warren (D-Mass.) accused President Trump of selecting Warsh to be his “sock puppet” on the Federal Reserve, doing his bidding to lower interest rates regardless of macroeconomic conditions. Warsh asserted he was completely independent and would guide monetary policy based on the economic data not the wishes of the White House.

But that assertion was in doubt in his first two Federal Open Market Committee (FOMC) meetings this summer. Despite ending the policy statement with a blunt sentence that “the Committee will achieve price stability,” the Fed did not raise rates even as inflation remained elevated amid a supply shock emanating from the war with Iran. Considering the solid labor market, inaction by the Warsh Fed could have resulted in a significant loss of credibility.

The central bank avoided that on Wednesday when, for the first time in three years, the FOMC voted to raise interest rates. The move to a new range of 3.75-4.00%, widely expected, was unanimous (12-0). Moreover, in its new Summary of Economic Projections (SEP), a majority of Fed voters favored a second hike on December 9, with four voters also favoring an additional hike on October 28. According to its new SEP, the Fed now expects to cut interest rates in 2028 and 2029.

“Inflation is too high and has been for too long,” Warsh said in his press conference. “Today’s action starts to show that we’re serious about this.”

The financial markets believe him now. Two-year Treasuries yielding around 4.75% (up from 4.10% in late June), the bond market is pricing in an 80% chance that the Fed will hike rates at least once more by year-end. Traders are also forecasting a total of three more quarter-point hikes by the middle of 2027. Benchmark 10-year Treasury yields spiked to a 19-year high of 5.02% on Wednesday, up from 4.35% in late June. The bond market seems to believe that the Fed should unwind the three quarter-point insurance cuts it implemented in the second half of 2025.

Is this Fed really data dependent? At the Jackson Hole central bank symposium in late August, Chair Warsh implied that the July Consumer Price Index (CPI) inflation report would be crucial for the September policy decision. After peaking at a 41-year high of 6.6% year-over-year (y/y) in September 2022, core CPI inflation (which strips out volatile food and energy prices) declined to a five-year low of 2.4% y/y in August 2026. But voting members seemed unconvinced the dip was sustainable given the spike in energy prices due to the Iran war, deepening concern that price pressures would bleed into the broad economy eventually. They found support for this opinion in the hot month-over-month data, as core CPI rose 0.3% in August compared to July’s 0.2% rate.

PCE revision on the way The core Personal Consumption Expenditures Index (PCE) peaked at a 39-year high of 5.6% y/y in September 2022 and declined to 3.3% in July 2026. The Bureau of Economic Analysis will release the August PCE report on Sept. 30. In addition, it will unveil its annual benchmark and methodology revisions for this inflation measure. We expect the changes will reduce core PCE by an additional 0.30% y/y. In the new SEP, the Fed increased its expectations for core PCE inflation at year-end 2026 to 3.4% from 3.1% in June. It kept its 2027 estimate at 2.5%, increased its 2028 forecast to 2.2% and initiated a 2% forecast for 2029. So, the Fed expects that it will not reach its long-standing 2% inflation target for core PCE for at least two years.

Other changes to the SEP The central bank indicated it anticipates the US economy to strengthen:

• Gross domestic product The Fed increased its estimate for GDP growth this year from 2.2% in June to 2.3% now, compared with 2.1% in 2025. That’s in line with our 2.3% forecast here at Federated Hermes. The Fed raised its 2027 forecast from 2.3% in June to 2.4% now, compared with our 2.9% forecast. The Fed left its 2028 forecast unchanged at 2.2%, and it initiated a 2029 forecast at 2.1%. 
• Labor market The Fed reduced its estimate for the unemployment rate (U-3) to 4.1% from 4.3% in June. That is in line with the actual rate in July and August 2026. Nonfarm payrolls have grown an average of 107,000 jobs over the past six months, compared with an average of only 10,000 in 2025. The Fed expects U-3 to stay at 4.1% in 2027, 2028 and 2029.

What will a rate hike achieve? Rather than look through temporary energy supply shocks due to the war in Iran, the Fed may decide to tighten more in coming months and quarters. But will higher interest rates actually slow the AI data center build-out, blunt the impact of worsening reciprocal tariffs, or open the Strait of Hormuz? The Fed must believe that inflation from these issues could seep into the greater economy and become embedded in the expectations of businesses and consumers.