Notes on the Week Ahead

This has been a year of distinct seasons for financial markets. The first quarter was dominated by the joint U.S./Israeli attack on Iran and its aftermath. The second was about booming tech earnings. The third quarter saw a sharp rise in long-term interest rates due, in part, to new leadership at the Federal Reserve. In the fourth quarter, the focus will be on U.S. midterm elections and their implications for the economy and markets.

On balance, I don’t believe that the Federal Reserve should have raised interest rates last week. However, I must confess that there was one reference in Chairman Warsh’s press conference that left me distinctly uneasy. He noted that year-over-year inflation rates, as measured by the core personal consumption expenditure (PCE) deflator and the core consumer price index (CPI) were running at about 3.2% and 2.4% respectively.

In the Broadway musical, Fiddler on the Roof, Tevye, the well-meaning patriarch of a poor family, has to make some tough choices in a complicated time.  Tevye, (who always reminded me of my father-in-law, Bill), has trouble deciding and three times during the play the music comes to a halt as he wanders through a long soliloquy of “on the other hand’s”. The Federal Reserve also has a tough choice to make in a complicated time.  We now believe that they will raise rates this week.  However, it is important to understand the logical twists and turns needed to reach that conclusion in order to trace out a potential path forward for the economy, interest rates and asset class returns. To bring some structure to the argument, the issues can be divided into three sections: the economy, the FOMC itself and the importance of Fed credibility.

The era of low growth, low inflation and super-low interest rates that followed the Great Financial Crisis was christened by Mohamed El-Erian as “The New Normal”. While this episode largely came to an end with the post-pandemic growth and inflation surge, real interest rates had generally remained below the levels that prevailed in the decades before the financial crisis until recently. However, a steady bond market selloff in 2026, which accelerated over the summer, has now pushed real long-term Treasury yields to their highest levels since 2010.

In a generally upbeat Jackson Hole speech on Friday, Fed Chairman Kevin Warsh asserted that “labor markets are consistent with full employment”. Given that the current unemployment rate, at 4.1%, is the lowest it’s been in 18 months and is also lower than it has been 88% of the time over the past 50 years, it is hard to argue with the Chairman’s assessment.