Will markets get a definitive answer regarding further hikes to the federal funds rate? For now, the situation remains ambiguous. On one hand, key Fed policymaker Kevin Warsh points to persistently high inflation and financial conditions that remain insufficiently tight. On the other, he acknowledges that monetary tightening is hitting the artificial intelligence sector, which currently serves as the primary driver of economic growth. In essence, the EUR/USD pair priced in the notion that the Fed will not “saw off the branch it is sitting on,” prompting a bounce from its 17-month lows.
Warsh has effectively challenged traditional economic theory, which posits that low inflation is impossible in a robust economy. In his view, the surge in labor productivity, driven primarily by AI technologies, allows the economy to expand without triggering price overheating. However, a risk lurks here: companies in the AI sector are highly sensitive to the cost of borrowed capital. Excessive monetary tightening could lead to the bursting of the stock market bubble, thereby depriving the economy of its main trump card.
Markets have concluded that the Fed is unlikely to take such a risk. Although a December rate hike remains priced in, the probability of three tightening cycles over the next 12 months has dropped from 67% to 58%. In response to Warsh’s assertion that the fight against inflation should not equate to halting economic growth, the yield on Fed-sensitive 2-year Treasury notes declined, while the yield on 10-year bonds rose.
In our view, Kevin Warsh has finally shown his hand. He genuinely believes that AI will drive productivity gains, enabling the economy to grow faster without inflationary spikes. This stance is finding support in the White House: Treasury Secretary Scott Bessent has already expressed confidence that the Fed will successfully strike a balance between inflation and unemployment. Judging by the lack of widespread dissent, this view is shared by the majority of FOMC members.
However, there is one significant risk factor: the conflict in the Middle East shows no signs of abating. This implies that the rise in core inflation driven by energy prices may prove to be more than a transitory phenomenon, much to the dismay of the US administration and, likely, Warsh himself. Only the upcoming Consumer Price Index (CPI) report will be able to clarify the true picture. Until its release, the US dollar will likely remain under the sway of the rhetoric from the October FOMC meeting.
