U.S. economic outlook: The Warsh era starts with a great debate

Key Themes

• Warsh is starting his tenure at the Fed during a transition of sorts. Given the prior FOMC statement and the countless Fed speakers we’ve heard from since then, it seems Fed officials are in the midst of shifting toward a more neutral policy stance. And who can blame them? Headline and core PCE inflation are comfortably above the FOMC's target at 3.8% and 3.3% year over year, respectively. This is not an environment in which the Fed is in any hurry to continue easing monetary policy. And on balance, we have some sympathy for that. Sitting on the sidelines for now strikes us as prudent.
• The case for rate hikes does not appear compelling to us. A pivot away from cuts does not mean the FOMC is ready to hike either. Yes, the labor market has found firmer footing, but it is not overheating. The unemployment rate is near most estimates of full employment, wage growth is benign at ~3.5%, and leading indicators of labor demand such as job postings remain range bound. On the inflation side of the mandate, much of the excess inflation has been driven by supply side factors (tariffs, energy shock) that cannot be easily resolved by tighter monetary policy. This combination of factors is poised to put the FOMC on hold for an extended period.
• What would it take to get hikes? A hotter labor market and/or a worse inflation outlook. One of the most frequent questions we have fielded in recent weeks has been what would it take to get the Fed into a tightening cycle. We think they would need to see proof that the labor market is starting to overheat, not just that supply and demand have reached a healthy balance after last year's mini labor market swoon. A numeric example of what this might look like: the unemployment rate has been between 4.2% and 4.5% every month but one since February 2025. A sustained break below that range would be a clear sign of labor market tightening. Higher inflation also could push the FOMC toward hikes, especially if the inflation were broadly based or started to trigger a de-anchoring in inflation expectations. But, our current inflation forecast (3.2% Q4/Q4 on the core PCE index for 2026) is probably not hot enough to get them there alone.
• We will wait to hear from Chair Warsh before revising our fed funds forecast. At this point the cuts we have in our official forecast this year are simply a placeholder. We want to hear what Warsh has to say before officially yanking them. But as we have been flagging, we think the right move for the Fed is to sit on the sidelines. If a very dovish Warsh shows up, that may breathe some life into the utterly deflated prospects for a cut. Unfortunately for Warsh (assuming he actually does have dovish leanings), the economic reality is recent data and our sense of the FOMC's reaction function argue there is a high hurdle to cut at this juncture. But let’s see what he has to say.
• Will the positive growth momentum be sustained in the second half of the year? Despite the conflict in the Middle East, it has been a solid first half of the year for economic growth. Ditto for the labor market. However, some of the positive tailwinds for the economy are starting to fade (e.g., the tax cuts), while others are in limbo (e.g., tariff refunds/relief, rate cuts). We are not economic bears by any means, but we will need to see this recent run of positive data sustained before we alter our forecast for trend-like growth and stable labor market conditions in the months ahead.

Download the Full Report!