Barclays Turns Hawkish on Fed, Expects Two Rate Hikes in 2026

Federal Reserve Chair Kevin Warsh has indicated that the US central bank may need to raise interest rates in the coming months if inflation does not make sufficient progress towards its 2% target. Speaking at the Fed's annual conference in Jackson Hole, Wyoming, on Friday, Warsh acknowledged that recent US data showed inflation had cooled somewhat, but the figures did not indicate a meaningful improvement in underlying price pressures. Warsh's remarks reflected a more hawkish assessment of the US economy, indicating that inflation remained elevated, financial conditions were not sufficiently restrictive, and labour-market conditions were broadly consistent with full employment. "Here is my standard: We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do. That's our job ... our mandate ... and our charge to keep," Warsh said, adding, "The Fed's predominant focus right now should be on prices." The Fed chief did not suggest a rate hike was imminent, but his comments offered a clearer indication of his concerns about inflation and appeared to reassure Wall Street that controlling price pressures remains a priority for the central bank.

Inflation stood at 3.7% in July according to the Fed's preferred measure, well above its 2% target, with price pressures having cooled in June and July after rising sharply in May as gas prices surged. Goldman Sachs notes that 54% of goods and services in the PCE basket recorded price increases of more than 3% over the past 12 months, which is well below the post-pandemic peak of around 77% but remains significantly above the 32% level recorded during the two decades before the pandemic. More than half of the goods and services tracked by the government recorded price increases of 3% or more over the past year, which was down from the pandemic peak but remained "well above" the roughly one-third that recorded such increases in the two decades before the pandemic. Warsh said inflation data "are more concerning" than trends in the labour market, where unemployment remains low, and also said inflation was unlikely to return to the Fed's target on its own. Barclays nevertheless expects monthly inflation readings to soften considerably, however, the brokerage warned that unfavourable base effects could make progress on longer-term inflation measures more difficult through the end of the year.

The speech pushed expectations for higher short-term interest rates higher in the bond market, with the two-year Treasury yield, which closely tracks expectations for the Fed's federal funds rate, jumping 11 basis points to 4.34%, reaching its highest level in a month. The 10-year Treasury yield rose 5 basis points to 4.72%, while the 30-year yield gained 1.6 basis points to 5.206%. According to CME data cited by Reuters, financial markets were pricing in a roughly 60% probability of a Federal Reserve rate increase at the September meeting, up sharply from about 35% before Warsh's speech. Interest-rate futures have similarly reflected stronger expectations for a near-term increase in borrowing costs. Attention is now turning to the Federal Reserve's policy meeting scheduled for September 16, when investors will look for clearer signals on the trajectory of interest rates. The decision will be closely watched as markets assess whether persistent inflation pressures and a relatively firm labour market are strong enough to prompt the Fed to tighten policy further.

Ed Yardeni, President of Yardeni Research, expects the Federal Reserve to raise interest rates by 25 basis points in September, saying the move would help restore the central bank's credibility on inflation. Yardeni says the Fed may need to do more depending on how inflation and the bond market react, with the next consumption deflator reading likely to be an important indicator. The next inflation number that's going to be relevant here is going to be at the end of next month, another consumption deflator measure. The Cleveland Fed, which monitors that situation, says that the number for August is going to be up 0.3%, which again keeps the year-over-year number over 3%. Yardeni also pushes back against concerns of stagflation in the US, saying domestic demand remains strong despite some weaker headline growth numbers. He points to robust consumer and business investment demand and says the artificial intelligence (AI) boom has also distorted gross domestic product (GDP) figures as imports of goods needed for the boom have surged. Yardeni notes that private credit and private demand for goods and services is very strong, growing more like 3% than 2%. "The GDP number has been affected by the fact that we've got an AI boom, and we don't make everything we need for that boom. So, our imports have surged from South Korea, Taiwan, also from Vietnam, and that depresses GDP," Yardeni explained. "When you look at the domestic demand in the United States, it's very strong, both consumers and investment demand, business investment."

Goldman Sachs sees a September rate hike as a possibility if upcoming inflation data comes in hotter than expected, but maintains its base case for no change in September. The investment bank noted that a firmer-than-expected August CPI and PPI reading could prompt the Fed to raise rates, while their base case remains for no change in September. Goldman also believes the recent improvement in inflation has not been enough to signal a meaningful shift in underlying price pressures. "Why the market is modestly reacting is he (Warsh) is very adamant that the 2% inflation target is going to remain. He is reiterating the hawkishness, but in a more of a consistent way than an incremental way," said Mark Hackett, chief market strategist for Nationwide. "There's been somewhat misguided thoughts among investors that this would soften a little bit. Clearly, that's not the case," he told Reuters. "We're moving up on six years where we've been above target" on inflation, former Philadelphia Fed President Patrick Harker said. "You can't keep saying this is our job" and then not act, he added. "As the old saying goes, actions speak way louder than words."