We have a mantra now, and the mantra is this: we must be confident that underlying inflation is moving to our objective clearly and at sufficient speed. That's the phrase he used in Wyoming. That's the phrase he used today. He's telling the world this is the test we apply to see whether monetary policy is where it needs to be. Are we at target? Target is 2% PCE. Are we moving to it fast enough? If the answer is no, we're going to tighten policy. That's a reasonably clear statement of the reaction function, and I think gives markets something to work with that they need.
Welcome to Prof G Markets. I'm Ed. It is September 17th. Let's check in on yesterday's market vitals. The major indices fell following the Federal Reserve's interest rate decision. More on that in a second. Treasury yields rose. The dollar strengthened. And finally, bank stocks had their worst day since February on concerns that higher rates will slow lending growth. Okay, what's happening?
The Fed just raised rates for the first time since 2023. In a unanimous vote, officials raised rates by a quarter point, and the Fed's forecast shows an additional hike is likely this year. The hike is an attempt to cool inflation, which has been above the Fed's target for five and a half years. And in his remarks, Walsh said that, quote, 'This summer's inflation readings do not tell me that underlying trends have meaningfully improved.' Investors largely had expected this outcome. On Kalshi, the odds of a rate hike rose to 88% ahead of the decision. Following the decision, the yield on 10-year Treasuries hit a 52-week high. The 10-year climbed back above 5% and stocks fell. Joining us to discuss the Fed's decision and what to make of it, we are joined by Robert Armstrong, author of the Unhedged newsletter and US financial commentator for the Financial Times. Rob, it's great to see you. We have finally gotten a rate hike, a quarter-point hike, a unanimous decision. Yes, lots we could say, but I'll start with your initial reactions to the news.
Well, we can put to bed the theory that Kevin Warsh is Donald Trump's sock puppet. I had never bought that theory, particularly for the simple reason that I don't see what's in it for Warsh playing the part of the sock puppet. He had nothing to gain by doing that. He's in a good position to go his own way. So I think that was becoming clearer as the weeks went on, but now it's very clear: he has hiked despite the threats and protestations of the president. So that is point number one. Point number two, and you mentioned this, which I think is very interesting and very important for this hike, is the unanimity. It was not at all obvious going in that all the voting members were going to agree on this outcome. Several members of the committee had made slightly dovish noises going in. So this is a very good sign for the Fed chair's credibility. Or it might be, right? There's two ways this may have happened. Either he wanted to hike and he got everybody on board, or almost everybody was on board and he wasn't, and he joined the crowd so he didn't look like a weenie, right? You know, I think it's probably the former.
But there is a little interesting detail you might have noticed about this in the notorious dot plot, which is this graphic they include which shows for this year and several coming years what each member of the committee believes is the appropriate monetary policy. There were two dots that showed that the appropriate monetary policy for the end of this year is the rate we were at before the rate hike. So what are those two people thinking? We agree, we vote with you to raise the rate today, but we think we're going to cut by the end of the year. So that was like this weird, like, what are we doing? Maybe that's a good argument to go with Warsh and dismiss the dot plot altogether. Get rid of the thing. But the important point was the committee as a whole agreed. That puts them in a strong position. Politically, sends a strong message. I think the third thing I would point out is with each meeting, we're finding this Fed chair is finding his feet and we're getting to know him a little bit better. And you know, his first two public appearances were terrible. His appearance at Jackson Hole was better. I think with this appearance, we get a still clearer sense of who he is. And we have a mantra now.
And the mantra is this: we must be confident that underlying inflation is moving to our objective clearly and at sufficient speed. That's the phrase he used in Wyoming. That's the phrase he used today. And what he's doing there is describing the Fed's reaction function. He's telling the world this is the test we apply to see whether monetary policy is where it needs to be. And there's some vague elements of that mantra. What is sufficient speed, etc. But you know that that's the mantra. Are we at target? Target is 2% PCE. Are we moving to it fast enough? If the answer is no, we're going to tighten policy. That's a reasonably clear statement of the reaction function, and I think gives markets something to work with that they need.
Why do you think it was unanimous now? Because inflation has been hot for a long time. We had the same inflation report the previous month. We've had even higher readings before that. And it was such a large debate in politics, in economics, everyone going back and forth, and then suddenly on this occasion they all agreed with each other. Yes, inflation is a real problem that we need to do something about now.
Well, remember what we talked about last time on the show, which is that in central banking, how you say it is more important than what you say or do, right? And so if you're going to move, it helps a lot to move unanimously. It just means the move is more effective, right? You know what I mean? So I wonder if in that room, and when we get the meeting minutes in a couple of weeks, we might get a slightly better sense of this. Once you get to a majority and it's clear you're going to hike, everybody's like, 'In for a penny, in for a pound. If we're doing this, we're doing it.' You know, we don't want to say to the world, 'We're a divided committee.' You know, it's one thing to have 10 votes and then two dissenters. I think that's normal and fine. But if you're going to be like, you know, whatever it is, 60% of the committee voting for it, no, I think let's go on. And by the way, Ed, it's particularly important at this time when people are still asking questions about the independence of the institution. So here is the Fed saying, 'We know we're listening to what the president is saying, and if you screw with one of us, you're screwing with all of us, right? You're not going to divide this committee, right?' And that's a statement about Fed independence, which I think is a positive one.
Let's talk about the implications here. Clearly the point is to get inflation under control, but I think something that a lot of people are debating is will this actually move the needle considering that the problem, the real problem, is a war in Iran causing a supply shock to oil, oil prices then rising, causing higher gas prices, higher diesel prices, and funneling through to everything else. The question being, okay, we're going to try to slow down the economy, but is that actually going to solve the problem that we're trying to address, which is higher prices?
Warsh had that exact question put to him, and he said, 'We can't control any one price, whether it's the price of oil or peanut butter. What we can do is we can see that price increases don't become diffuse, right? They don't spread from oil to elsewhere.' So his answer to that question would be, 'No, I can't control the oil price. That clearly is affecting inflation, but what I can do is make sure that the oil price doesn't start to infect wages and go from wages to prices of consumer goods and so forth.' So at a certain point, it is absolutely true that the Fed cannot create hydrocarbon atoms, right? Which would be a very useful thing if they could, but they can prevent infection, and they decided that's what they have to do right now. But you're absolutely right. There's a lot of people out there who think this is just crazy. It's hiking into a supply shock, and it's a crazy thing to do. I guess I lean towards the Fed on this topic, but I agree it's a real debate.
Yeah. During the conference, he also said that the most important asset price in the world is the 10-year Treasury. The 10-year yield settled near 5% on Tuesday. It briefly hit 5.04, which was the highest number since 2007. It's around 5% now. He said that the yield has risen first and foremost because the economy has strengthened.
Well, what does that mean? Okay. So, in general, all else being equal, if you have an economy that is growing faster, you are going to have higher interest rates because in a faster-growing economy, there's more competition for capital, more things to do with capital. Capital costs more. That is fair. Is some of that going on right now? Well, yes, I think so. We just got a very strong, for example, retail sales number, or a solid retail sales number this morning. We have the AI boom going on. Private sales to final domestic private consumers, which is kind of GDP without the nonsense, is like 3% or something. Best guess, right? So you get 3% growth, you have 3% inflation, that means nominal growth of 6%. You're going to get higher rates. You know what I mean? So growth is part of it, but I wouldn't say it's the predominant part. I think the predominant part of it is in America and in the rest of the world, we're looking at inflation and everyone knows central banks, including the Fed, are going to raise rates. And that echoes down the interest rate curve to the long end. So it's not that the world expects more inflation. What the market is telling you is inflation pressures are high. We think the central bank will get them under control by raising interest rates, and therefore we, in anticipation, are, you know, selling 10-year bonds, the yield is going up. So inflation is the main story. But I'm not one of the people who says growth has nothing to do with it. Growth has something to do with it. And interestingly, Warsh didn't say, 'Of course inflation is part of the picture.' He used a euphemism, you know, he said geopolitics is part of the picture, but for geopolitics read inflation, I think, in his comments. Now he mentioned a third factor, competition for capital from hyperscalers. I think again that's part of the story but a small one. Main part of the rise in yields is inflation and central banks. I would say growth, hyperscaler investment, all this stuff, they're part of it, but not a huge part of it.
This event, this day, is something that a lot of people have been making predictions about and wondering about for a very long time. At the beginning of the year, we went into the year. I think you and I recorded a podcast talking about the point, which is that one tailwind for the stock market right now is the fact that we're probably entering a rate-cutting environment. That didn't happen. And now here we are. We're entering a rate-hiking environment. And I think it would be fair to say that if we're going to raise rates this time, oftentimes what happens is that we keep raising them. And so I guess the question is, what does that mean for the stock market? Higher interest rate environments, generally speaking, aren't good for stocks, right? Do you think that's going to be the case?
Okay. The reason a high-rate environment would not be good for stocks is that they discourage certain kinds of activity classically, right? It becomes more expensive to finance stuff, and that slows down the economy, and there's other psychological factors, but let's just concentrate on that one mechanism for now. The standard mechanism by which that happens is the housing market. The thing where you have the most direct channel to the economy is you raise rates, mortgages get more expensive, housing slows down, that's a big swing factor in the economy, the economy slows, etc., etc., stock market gets hurt. Well, we are in the situation now, and you can call this fortunately or unfortunately as you please, where the housing market already sucks. So it can't be damaged that much more by higher rates. Nobody's buying or selling houses to begin with. So that's good. Next question: are these rates high enough to derail the AI investment bubble? You know, you get a higher financing cost out the curve, you know, the 10-year, certain projects, you know, out there in some desert building a data center, whatever else, become less viable? The payback no longer looks any good? You don't want to do it anymore. So some air comes out of that bubble. Well, so far the people who are doing this investment are extremely price insensitive, right? You're building a data center, the price of an Nvidia GPU goes up 50%. Fine, I'll pay it. Whatever it takes, right? You know what I mean? So like another 100 basis points on your interest bill are not going to bug you. Could that change? Right? You know, if the bubble is slowing down anyway and people are suddenly becoming more price sensitive about their AI investments, that part of the economy could slow, and that would connect in a very obvious and very direct way to the stock market.
I would 100% agree. That seems to be the thing to focus on is what are the borrowing costs of the AI companies? What are the borrowing costs of the big tech companies when they are spending all of this money, which is really what is driving so much of the returns, so much of the GDP growth? And could this be the thing that makes that more difficult, especially when they're issuing so much debt to build what they're building?
Absolutely. And 25 basis points is not going to change a decision right now. 75 probably isn't going to change a decision, but it's going to be one factor in a decision down the road, right? Like interest costs don't matter until they do, like a lot of things. And they clearly don't matter right now, but six months from now, we'll have to see.
Final question. As you mentioned, this is Walsh officially defying the president. Have we heard from the president yet? Have you been watching your Truth Social account, Rob?
I haven't opened up my app. I usually check it every day. I love that app.
Maybe in the White House, they just have made sure the president has not seen his phone. They haven't told him. Exactly. He has no idea what's happening. He'll have an aneurysm. My question to you, what do you think happens here politically speaking? Is this another Powell versus Trump moment? Are we going to see Walsh versus Trump?
Well, if we haven't heard anything now, two and a half hours after the announcement, that's probably a good sign, right? I just think, I mean, I've gotten out of the trying to understand Trump business. But I just think this is a losing battle for him, isn't it? Yeah. And doesn't he acknowledge that at some point if he's, you know, I just think what can he do? He tried this on with Powell. It didn't work. Scott Bessent probably in the back of his mind knows rates need to be higher if they're going to keep the 10-year yield under control, which after all, you know, is good for the government financing cost in a lot of ways. You know, I just feel like it's a loser for Trump and he'll probably make a little noise and move on. But again, you know, there's no money in predicting this guy. Anything's possible, I'm afraid.
