Warsh’s policy framework creates investor uncertainty, Citadel Securities says

Investing.com -- Federal Reserve Chairman Kevin Warsh is generating uncertainty for investors by committing to control inflation without providing details on his approach, according to Citadel Securities.

Warsh has stated multiple times that the central bank must address consumer-price increases that have surpassed its target for five consecutive years. The Fed kept interest rates unchanged last week, though three policymakers supported an immediate increase.

Warsh said the recent increase in Treasury yields had already tightened financial conditions, allowing markets to perform some of the Fed's work. He also indicated the central bank might reconsider whether its current preferred inflation measure should remain the benchmark after its policy framework review.

Investors sold long-term Treasuries following the decision, which raised inflation expectations and lowered the dollar and stocks. The market moves highlighted "a challenge to the credibility or clarity of the policy framework," wrote Nohshad Shah, Citadel's head of EMEA fixed-income sales, in a note.

Shah said relying on markets to tighten financial conditions risks creating a negative feedback loop. Higher long-term borrowing costs encourage the Fed to delay rate increases, which would likely prompt investors to demand larger inflation and term premiums, pushing yields higher.

"The Fed holds because markets have tightened, while markets tighten because the Fed has held," Shah wrote.

Shah noted that not all yield increases tighten financial conditions equally. Higher short-term rates driven by expectations of Fed tightening help restrain demand, while rising long-term borrowing costs fueled by investors seeking greater compensation for inflation and policy uncertainty could erode confidence in the central bank's commitment to price stability, he wrote.

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