The Fed under new management

Hello, I'm Aline van Dyne in New York and welcome to the Macro Brief from HSBC Global Investment Research, the podcast that looks at the issues driving financial markets. Now today we're looking at one of the biggest changes for global financial markets, new management at the U.S. Federal Reserve, the world's most influential central bank.

Kevin Walsh held his first meeting this week as chair of the FOMC, where U.S. policymakers decided to keep rates steady. But a lot more happened and a lot is at stake, not least given concerns about political pressure on Mr. Walsh to lower rates.

So a new chair who wants to change things and a U.S. economy that is robust with inflation still elevated. Let's get into what this all means for the U.S. and beyond. I'm joined by Ryan Wang, our U.S. economist.

Great to be here. Dheeraj Narula, our U.S. rates strategist. Good morning.

And our special guest, Fred Newman, who is our chief Asia economist and also host of our sister podcast, Under the Banyan Tree. Fred, welcome. And you're going to be answering some questions this time, not just asking them.

Thank you. Wonderful to be here in New York in the studio. First time.

Great. Great. Welcome.

Now, Ryan, let's start with what actually happened at the FOMC. What's going on in terms of interest rates? Yeah, it was the first FOMC meeting under the new Fed chair, Kevin Walsh.

And there was a new communication style. We saw that in the form of a much shorter, much more direct policy statement. And Kevin Walsh had previously expressed some reservations about the specific forward guidance that the Fed has been providing in the form of the famous DOTS projections, the economic projections for the next several years.

And this was kind of interesting because actually the Fed did continue to publish those projections. But Kevin Walsh individually refrained from submitting his own views about the economy and where policy rates should be headed. So it was a little bit confusing in that sense.

But markets did react to the rate projections, which have changed substantially since earlier this year. And the Fed were thinking about rate cuts. Now the question is all about possible rate hikes.

And we saw a divided committee with basically half of the FOMC thinking that rate hikes might be appropriate later this year. Dheeraj, what was the market reaction? The market clearly took this as a hawkish Fed meeting.

And I would say there's two reasons for that. The first, as Ryan pointed out, was that the DOTS that were submitted indicated that nine out of 18 policymakers submitting a DOT plot were looking for rate hikes this year, including six that were looking for multiple rate hikes. That went pretty much significantly more hawkish than most investors were expecting.

The second reason for kind of this hawkish move in the upwards increase in front-end rates was the focus placed on inflation. So the policy statement itself, while much shorter than the previous one, referred to the price stability mandate in a very decisive way, saying the committee will deliver price stability. In contrast, the references to the job market kind of only pointed out stability in the unemployment rate.

So clearly, this was very attuned towards the inflation side of the Fed's mandate. So this is important. Does this suggest, Ryan, that Kevin Walsh is indeed fairly hawkish?

Well, it was clear that Chair Walsh emphasized many times that the Fed has responsibility for inflation. And this also was really the final line of the policy statement that the Fed will deliver price stability. Now, the question is, will that actually require rate hikes later this year?

We have long been forecasting that the Fed would not make any changes to the Fed funds rate, which, of course, was left unchanged at the latest meeting and is sitting in this range between 3.5% and 3.75%. And it also has to do with the evolving risks to inflation. Of course, there's been a big energy price shock in recent months.

But there is some prospect that energy prices might ease up a little bit, depending on what we see with respect to the situation in the Middle East. So Fred, is the potential for rate hikes in the US, which is not our base case, but would a shift in that direction have an impact on Asian economies, for example? Yeah, of course.

Asian central bankers are watching the Fed just like all of us do. And it's very important for the region. Now, what's interesting here is that we've just seen a kind of easing of oil prices.

So the fear that higher energy prices will drive inflation a second half have kind of calmed down a little bit. And so you'd think, OK, then central banks don't need to be hawkish. They can maybe relax a little bit.

But central banks in Asia also are kind of beholden to the Fed. So if we do get the markets pricing in more Fed hikes, that could mean a stronger dollar. And that means depreciation pressure on local currencies in Asia.

And then central banks need to tighten monetary policy, because weaker currencies in Asia themselves can be inflationary. So think of the Bank of Japan. The yen is weakening.

If the dollar is strengthening, then you still have an argument for tightening. So we had a brief respite here, a few days when energy prices were down. People thought, oh, maybe there might be no need for Asian hikes.

And now we've got Mr. Chair Walsh coming through very hawkish. And hikes are back on the table.

So hikes are back on the table. But beyond the interest rate picture, there's a lot of other potential changes. Five task forces, I believe.

Yeah, absolutely. So we had a taste, as I mentioned, about the new communication style under the Walsh-led Fed. And that's really the subject of the first of five task forces, Fed communications.

But there is four other task forces that are expected to deliver results, some sort of results by the end of this year, according to Mr. Walsh. And those relate to the balance sheet and also to the economic data sources that the Fed uses to make its decisions, to the big theme about productivity and the labor market in the context of an AI economy, and finally, just how the Fed should manage inflation in the first place.

The inflation framework, so to speak. So I don't think any of these frameworks, reviews, or task forces are going to necessarily deliver immediate changes to how the Fed does its business, with the exception of the communication style, which I think has already clearly evolved. But these are all major issues.

And importantly, that fourth task force is a critical question. How is the US economy really going to evolve in the next few years with these significant technological changes? Yeah, and I think it's interesting to see more broadly how the bond market has reacted to kind of both the near-term view that there is clearly a focus on bringing price stability about.

But if you look at the long end of the Treasury curve and where long end rates have sat, they've actually ticked down in the aftermath of the meeting. And I think that's a very clear message that the bond market believes in this credibility of inflation fighting. It kind of believes that the Fed will ultimately deliver a policy setting that's credible, that's targeted towards its mandates.

And in fact, despite greater, perhaps, uncertainty about what any individual meeting outcome might be, the overall trajectory of rates is kind of something the market has more confidence in. But what about volatility, though? All this uncertainty, task forces, is there increased volatility in the markets?

I would say yes, especially in terms of the individual meetings and the very front end of the Treasury curve. So we've kind of gotten used to a regime where bond markets were fully pricing in the outcome of every single Fed meeting ahead of time to the point where any decision that deviates from that from the Fed would create a lot of chaos. And I think one of the points that Chair Walsh emphasized was that this new regime of reduced foreguidance was motivated in some part by the new ability of the Fed in this case to then take financial markets as a cue rather than having this kind of back and forth between Fed guidance and markets reacting and going kind of circular with that.

That's interesting. So you're saying a bit more uncertainty near term, which means more volatility, maybe near term rates, but long term actually a bit of anchoring because maybe a more hawker stance and so maybe long term rates feel more comfortable that inflation is coming down. But I want to ask Ryan here because there's been some suggestion that Chair Walsh might actually deemphasize the current inflation measure that the Fed has traditionally targeted with its core PCE that famously is kind of the key benchmark, if you will, the inflation target.

There's been in the run up in recent weeks a suggestion we could move to a different inflation gauge, trimmed mean is one of these technical terms thrown about. Has there been any sign of it or is it too early to talk about that? Because ultimately if we change how we define inflation, back to your point about markets, that will introduce some uncertainty as to where the Fed actually is targeting inflation.

That seems to me a big thing in a room. Was there any hint of that yesterday, Ryan? And this is, of course, also related to the 2 percent inflation target, right?

Yes, exactly. Yeah. Yeah, absolutely.

So the 2 percent inflation target, which is for headline PCE inflation, that was the one element that Walsh did confirm is here to stay. Now, this also relates to one of the task forces. There's a task force for that.

So this was the third task force, which is related to the data sources. And so it did come up indirectly, even though I don't believe the trimmed mean measure was specifically talked about at any great length. But the overarching vision from Kevin Walsh is that the Fed needs to analyze what are the true drivers of underlying inflation, right?

And we can't necessarily just put all of our eggs in this traditional core PCE metric, which excludes food prices and energy prices. But instead, maybe we do need to pay some attention to a trimmed mean measure, which excludes the tails in terms of the most rapidly rising prices and maybe the prices on the downside that are actually falling to get a sense of what is really the underlying trend. I think if you look at all the data, it's very clear that right now inflationary pressures in the United States are not as broad based as they were several years ago in the immediate aftermath of the pandemic.

Having said that, we are in the midst of another sort of supply shock. There are clearly some evidence of accelerating prices in certain areas. So it's that Judgment Act, which is going to inform this debate about, well, how do you even measure inflation in the first place?

Actually, I wanted to bring in a DRush here because just from an Asian perspective, based in Hong Kong, a lot of Asian investors are obviously still buying US assets. And what's very important here is, I suppose, that you get this ongoing demand for treasuries coming through from savers in Asia. And if that confidence wavers, that would have a big impact, I suppose, on the treasury market.

Have you seen anything that foreign investors are starting to pull back amid uncertainty, for example, around the Fed transition, amid uncertainty around the US budget deficit? Or in your analysis, does that not really matter? Is that not really a big driver?

So I would say when it comes to fiscal and supply demand narratives around the treasury market, it comes and goes in waves. So the fact that the US is running elevated deficits is not a new story to anyone. But I think the times it comes into the market is sort of only when you have multiple overlapping narratives.

So for example, last year, when we had the big tariff announcements, that coincided with the One Big Beautiful Bill Act, it coincided with the sovereign downgrade, it coincided with the debt ceiling issue at the same time. So at that moment, there was signs of these supply demand issues feeding through, long end rates really went up. But in hindsight, if you actually look at the foreign flows data, especially around April of 2025, foreigners were actually barely net sold.

The net outflow is, in fact, $40 billion only. And if you exclude Canada, there was actually positive flows into the US. So I think that any signs of confidence really shaking hasn't really fed through in the real-time flow data.

But I think there is also this reality that we are seeing meaningfully higher longer term rates than we had been used to for so many years. And so I think there is this element of now that we have this premium, investors are somewhat comfortable with the policy uncertainty and some of the volatility we've seen. Now, that's a good time to take a short break.

We'll be back with more soon. A quick message here from the Macro Brief team. If you're one of our listeners on YouTube, then we'll soon be moving.

To ensure you never miss another episode of the podcast, be sure to head to HSBC CIB on YouTube and click the subscribe button. Now, back to today's episode. And Fred, a question to you.

How much discussion is there now in Asia, for example, amongst the central banks that you cover so closely of any political influence on the Fed? Is that story slightly come and gone or is that another issue that could affect sentiments? Because especially if we do get into a situation where US interest rates might rise and if there is some political pushback, what do you think the implications would be of that?

There are a lot of discussions because Asian investors are so overweight US assets and that's a treasury market, but it's also the equity market, right? There's a lot of apprehension in Asia that follow US developments very, very closely. And so when you have uncertainties around a new Fed chairs coming in, the president has indicated rather have lower interest rates, that question is being asked.

I suspect that the Fed meeting that we just had in Warsh's comments, which were interpreted slightly more hawkish, would put a lot of those fears to rest. And one might also argue that maybe that was an intent here that in the first meeting to come out erring on the side of hawkishness to put to rest any doubts potentially. And that's why also, and Ryan has said that, it doesn't necessarily mean a hawkish comments that we will get rate increases, but maybe from a messaging perspective, it was useful to have the first meeting or a little bit side on the hawkishness to reassure for investors.

And I think I would echo that strongly and I think the treasury market's reaction has very much encapsulated that. And it was to track back to the earlier point, I think in particular, this firm commitment that we're looking to make a lot of change, but the 2% inflation target, whatever specifics with regards to the data that may be, that 2% number is not in question and the Fed will deliver on that. And I think that was important for long-end expectations to stay anchored and not have any fears that the Fed would tolerate anything.

That's right. Yes. So that communication strategy matters.

The other thing, Alin, is that, of course, the talking point in Asia is the U.S. deficit. So one is worries about, does the Fed pursue its mandate and maybe now these fears have subsided a little bit after the hawkish press conference, but we still run very large deficits here in the U.S. I think even Americans are comfortable about this.

But that's something that foreign investors watch. And so, Dheeraj, do you see a risk premium there coming in, not from an inflation perspective, but a little bit that the deficits ultimately matter or is it not yet really relevant? And we're talking here about the fiscal deficits, obviously, not trade deficits, et cetera.

The fiscal deficits, of course. Yes. So the fiscal, the government spending, it's at historic high levels.

Absolutely. And I think it is certainly something that comes into market focus once in a while, running two trillion deficits pretty much year on year. That's 6% of GDP.

With regards to risk premium, I think we have priced some of that in. But I think one of the things that's kept it at bay recently, especially in the last two, two and a half years, is that the Treasury has refrained from increasing the supply of any of the Treasury securities from two years and beyond. So even though there's a need to fund the government and there is this deficit, it's being pretty much entirely funded incrementally by issuing Treasury bills, so very, very short dated debt that we still see very strong demand for from money market funds.

Even the Fed is now buying T-bills. So even though there is that deficit, there's not actually meaningfully more issuance coming through to the market. And I think the Treasury has given us forward guidance saying we're not going to do that anytime soon.

And that's quelled some of those concerns about the market's need to absorb it. But that doesn't resolve the issue. It just kind of pushes it back, maybe 2027, maybe the back half of this year, it comes back into focus.

And so I want to give Brian the last word. Brian, you've watched quite a few different Fed chairs in your career as a U.S. economist. What's on your mind as you look ahead to Kevin Walsh's term in comparison to what you've analyzed and experienced previously?

Well, I think what's clear is that there's an ambition to possibly make significant reforms. That is really what we can say at this point. We mentioned a few of the different areas that Kevin Walsh will be examining.

One that we haven't talked about too much is the Fed balance sheet. And that's very much related to what Dheeraj and Fred were just discussing with respect to U.S. fiscal deficits and the relationship between the U.S. Treasury and the Federal Reserve.

And so I don't think that Kevin Walsh is necessarily going to make immediate judgments about these big picture issues related to exactly how the Fed conducts policy. So this year is going to be about inflation and whether or not the Fed actually hikes interest rates. And I think as we move into 2027, it's these broader issues that will potentially take the fore.

Which could be pretty interesting. There's a lot to watch for. Well, there's plenty to discuss in a future podcast, Aline.

Exactly. I think we're going to be back. I think we're going to be back.

Thank you. You know where to find us. Yes.

Thank you so much. And again, welcome to New York. Thank you.

Thanks for having me. Yes. Thanks.

It's a pleasure to join you guys here in the Big Apple, in the studio now. It's actually a historic day because the New York Knicks, there's a victory parade. They are basketball champions.

Fred's looking at me with a blank face. No, I know. I've heard of basketball.

We have heard of the NBA and the Knicks, even in Hong Kong. So congratulations to the Knicks. And I just, my thought just went to the traffic in the day in New York City.

Slight look of panic. It will all be over by lunchtime. All the roads are closed, don't worry.

Thank you. So it's good to know that Fred has heard of basketball. Today's episode was hosted by me, Aline Van Dyne in New York and produced by Tom Barton in London.

Please like and subscribe The Macro Brief and Under the Banyan Tree, wherever you get your podcasts. Until next week, thanks very much for listening.