Chairman Warsh has promised to be an agent of change at the Federal Reserve, seeking to streamline communications and advance institutional reforms through a series of task-forces. These efforts come amid still elevated inflation and an administration focused on lowering borrowing costs across the curve. In this changing policy landscape, we examine how to think about the Fed and, when everything appears to matter, what matters most.

The immediate: The most immediate question for markets is when the Federal Reserve will next adjust rates. While U.S. economic data remain far from weak, growth has moderated and two consecutive soft CPI prints have given the Warsh Fed cover to pause. As a result, measures of Fed speaker tone have shifted from net hawkish to net dovish over the past two months (Figure 1).

Figure 1: Data slow down bolsters doves

Source: State Street Markets, MKT MediaStats

However, this dovish respite is unlikely to last indefinitely. Importantly, the shift has not been driven by Chairman Warsh himself. While broader interpretations of Fed communication have become more dovish, coverage of Warsh has remained consistently hawkish. When a large divergence emerges between perceptions of the Chair and the broader Committee, history suggests the rest of the Fed often shifts in a more hawkish direction to close the gap. With the current divergence ranking in the top 1% of observations since 2015, it would be difficult for the Fed to remain this degree of net dovish.

Adding to this, State Street's daily measures of online inflation suggest price pressures rebounded in August. Data through August 22 indicate that online prices rose an average of 37bps during the month, well above the historical average increase of 12bps. The more important question, however, is how broad-based these gains have been. Sector-level data point to underlying firmness, with household equipment, electronics and recreational goods all recording stronger-than-normal price increases. While this has been partially offset by softer trends in categories such as apparel, the broader picture suggests inflation remains sticky in key components of the core basket. That should place a floor under how dovish the Fed can become in the near term.

Figure 2: Not out of the woods when it comes to inflation

Source: State Street Markets, State Street PriceStats

Framing the bigger questions: Chairman Warsh has made clear his ambition to be a driver of change. With five task forces spanning Fed communications, balance sheet policy, data sourcing, productivity and workforce transformation, and the inflation framework, investors will have no shortage of developments to assess when evaluating the future reaction function and transmission of policy.

Each of these areas matters. Changes in Fed communications, for example, could meaningfully affect front-end volatility. However, one of the most consequential questions concerns the balance sheet. The size and composition of the Fed's balance sheet influence the cost of short-term funding, overall market liquidity, and ultimately financial conditions. As liquidity declines, institutional investors often reduce risk exposure, creating a powerful transmission channel from balance sheet policy to asset markets (Figure 3).

Figure 3 - Liquidity matters for risk appetite

Source: State Street Markets, Bloomberg

Figure 4 - Funding matters for equity exposure

Source: State Street Markets, Bloomberg

Importantly, a reduction in liquidity does not automatically trigger a wholesale exit from equities. Historically, more significant drawdowns in risk assets have occurred when funding conditions become stressed, illustrated by the navy bars above. We define such periods as episodes when SOFR trades above IORB.

This is particularly relevant given current positioning. State Street's Investor Behaviour data, which leverages aggregated real-money custody data, indicate that institutional investors' equity allocations are nearly seven percentage points above their average over the past three decades (Figure 5). With investors already heavily exposed to equities, understanding how market liquidity evolves under a changing Fed may prove critical for asset allocators and portfolio managers alike. The interaction between balance sheet policy, funding markets, and investor positioning could ultimately be more important than the path of policy rates themselves.

Fugure 5 - Equity exposure is well above average

Source: State Street Markets

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