The head of the Federal Reserve is in the throes of inflation Markets retreated from October's rate hike

Kevin Warsh refused to announce the possible decision of the Federal Reserve for the October meeting, despite the intensification of inflationary pressures in America; A position that reduced the expectations of an immediate increase in interest rates.

World Economy - Daniyal Rahimi; Just two days after the release of US inflation reports, both of which exceeded economists' expectations, Federal Reserve Chairman Kevin Warsh spoke about the country's economic outlook at the annual meeting of the International Monetary Fund.

Contrary to the concerns caused by the recent increase in prices in the financial markets, his assessment of the state of the American economy is still positive. Varash believes that the broad wave of investment, especially in the field of artificial intelligence, has increased the capacity of economic growth; However, this development itself can fuel inflationary pressures in the short term.

This duality becomes more important in a situation where the US central bank has to maintain a balance between maintaining economic growth and returning inflation to the 2% target.

Price pressure beyond the energy market

The rise in US inflation in September showed its first signs in the Wednesday report of the Bureau of Labor Statistics. The annual consumer inflation rate reached 3.7%; while economists expected it to increase to 3.6 percent. This index was 3.4% in August and now, with an increase of 0.3 percentage points, it has once again moved away from the inflation target of the Federal Reserve.

The major part of the monthly inflation growth came from the increase in energy prices. Gasoline prices rose 9.1 percent in September, explaining more than half of the overall index's 0.6 percent gain. However, consumer core inflation, which excludes food and energy, did not decrease, contrary to market expectations, and its monthly growth remained at 0.3 percent. The annual rate of this index also increased from 2.4 to 2.6 percent.

A day later, the producer inflation report exacerbated concerns. The producer price index increased by 1.3% on a monthly basis; More than double the 0.5 percent forecast by economists in a Reuters poll. Its annual rate also increased from 5.6 to 6.3 percent, recording its highest level since December 2022.

Energy played a decisive role in this sector as well. The energy price index among the final goods of producers increased by 10.8% and explained more than 80% of the price growth of this group. On the other hand, the price index of producers' services also increased by 0.8% and the cost of transportation and warehousing experienced a growth of 3.4%. Producer inflation excluding food and energy also increased by 0.7%; While its more limited measure, excluding commercial services, had a growth of 0.5 percent.

These details show that the increase in costs is not limited to the fuel market. Part of the price pressure has also reached transportation services, commercial activities and other goods; However, the growth of these groups does not necessarily mean the formation of a stable inflation process. The increase in energy costs can indirectly increase the price of services, and it is necessary to examine the data of the next few months to determine the sustainability of these pressures.

This information is important to policymakers, but none alone can be decisive about the sustained strength of demand or the future path of inflation. Evaluating the state of the economy requires the trend of a set of indicators of production, consumption, employment and prices.

What kind of economy is Varesh talking about?

In such an environment, Varesh started his speech with a different picture of the economic growth prospects. He mentioned the discussions that were discussed about the structural stagnation in the world economy about two decades ago; A view that considered the chronic weakness of investment and demand as a long-term obstacle to economic growth.

According to the head of the Federal Reserve, the American economy is now in a different position. According to him, the broad wave of investment shows that the growth capacity of the economy can still be increased and appropriate policies at the level of the macro economy and micro structures can provide the basis for the expansion of investment.

Varsh emphasized that this investment flow is not limited to artificial intelligence and is expanding to other sectors of the American economy. In his opinion, these developments have been the main factors of the economy's resistance against external pressures; The resistance that, considering the geopolitical tensions, the increase in energy prices and the tightening of the monetary policy, has been more than expected even for some policymakers.

This view is in line with the recent assessment of the International Monetary Fund. In the latest perspective of the global economy, the fund considered investment in artificial intelligence as one of the factors supporting growth and predicted that the world economy would grow by 3.1% in 2026. However, rising oil prices, high debt, and the possibility of reduced investment in technology are some of the risks that can weaken this outlook.

An important point in Varash's analysis is the distinction between investment growth and its effects on inflation. Increased investment can simultaneously strengthen future production capacity and, in the current situation, increase the demand for financial resources, labor, energy and equipment. For this reason, economic prosperity does not necessarily mean an immediate reduction in inflationary pressures.

In another part of his conversation with Kristalina Georgieva, CEO of the International Monetary Fund, Varsh described artificial intelligence as one of the most important economic developments of the contemporary era; An achievement that, in his opinion, can change the structure of production, employment and productivity in the coming years.

But along with his optimism about the long-term effects of this technology, he pointed to a fundamental issue in macroeconomics: artificial intelligence first boosts aggregate demand before increasing the economy's supply capacity.

This difference becomes important when we examine the stages of AI infrastructure development. Construction of data centers, development of electricity network, purchase of processing equipment and expansion of communication infrastructure require heavy investments. The increase in these expenses can increase the demand for energy, industrial equipment and specialized services and put more pressure on prices in case of limited supply capacity.

However, the long-term effects of artificial intelligence may move in a different direction. Increasing labor productivity, reducing production costs and improving the efficiency of enterprises can expand the supply capacity of the economy. In such a situation, the economy will be able to produce more products and services, without the growth in demand necessarily causing inflationary pressure in the same proportion.

Varsh emphasized this distinction and said that he is very confident about the positive effects of artificial intelligence on productivity, but the path to this stage will probably be accompanied by fluctuations and difficulties.

One of the most important uncertainties is the employment situation. The chairman of the Federal Reserve admitted that it is still not possible to speak with certainty about the consequences of artificial intelligence for the labor market in the next 12 to 18 months. According to him, even the market structure of this technology and which companies will ultimately benefit from massive investments are still unclear.

This issue is also reflected in the financial markets. In recent days, investors have become more sensitive to the high cost of financing companies active in artificial intelligence infrastructure and the economic return of their investments. As a result, a part of the same wave of investment that Varash considers the cause of economic growth, is now facing questions about the profitability and sustainability of financing.

Monetary policy in an economy that is observable with a lag

In explaining his approach to economic decision-making, Varsh pointed to an important limitation that monetary policymakers always face: many economic data are published when the developments related to them have already happened.

He explained that central banks have to use official statistics, market information, and models to determine the current state of the economy, each of which has limitations. On the other hand, forecasting the future is also faced with uncertainty, and it is not possible to make a decision about the current situation by relying only on long-term estimates.

This issue is particularly important for evaluating the effects of monetary policy. The Federal Reserve raised interest rates by 0.25 percentage points in September, but the impact of such a decision on consumption, investment and inflation is gradually becoming apparent. Even the increase in the yield of treasury bonds and the cost of financing also affects the economic activity from different paths and intermittently.

Therefore, the increase in inflation in September cannot be seen as a sign of the failure of the recent monetary policy; In the same way, the possible reduction of inflation in one month alone does not prove its success. The main issue is the medium-term trend of inflation and the level of stability of price pressures.

The inflation target of the Federal Reserve is also determined based on the Personal Consumption Expenditure (PCE) index, and policymakers must assess whether the set of economic developments has increased or decreased the probability of a stable return of this index to the 2% range.

Meanwhile, the nature of inflationary shocks is also important. The increase in energy prices caused by supply disruptions has a different mechanism than inflation that originates from demand exceeding the economy's capacity. Monetary policy cannot directly solve the shortage of oil or the disruption of energy transmission routes, but it can limit the risk of expansion and persistence of price pressures by affecting demand and inflationary expectations.

Varsh announced at the Bangkok meeting that the developments of the world economy since the September meeting of the Federal Reserve largely corresponded to previous assessments. While emphasizing the central bank's commitment to maintaining price stability, he declined to provide a forecast on monetary policy decisions in the remaining meetings of the year.

This position is consistent with an approach that prioritizes the evaluation of the economy's conditions at the time of decision, instead of announcing the definitive path of the interest rate. However, in this conversation, Varsh did not provide an explicit conclusion about the adequacy of the current interest rate or the necessity of increasing it in a specific meeting.

What did the markets take from the words of the head of the Federal Reserve?

While the release of two unfavorable inflation reports had initially boosted the possibility of an interest rate hike in October, Warsh's remarks and recent positions by other Fed members helped moderate those expectations.

The probability of an interest rate increase in the meeting on October 27 and 28 decreased from around 28 percent on Thursday to 15 percent on Friday. The market still rates high the probability of an interest rate hike by the end of the year, but the likely time of the next action has been moved to the December meeting.

This shift does not mean providing an explicit signal for interest rate stabilization by Varash. He did not announce the future decision and the change of market expectations is also the result of a set of economic data and policy makers' statements.

In the Treasuries market, concerns about rising interest rates initially pushed yields higher, but this trend reversed as demand for safe-haven assets and concerns about valuations in technology stocks increased. The yield of 10-year US bonds, which had previously reached above 5.3%, decreased to the range of 5.08-5.09% in Friday trading.

This reduction in the conditions of high inflation indicates the importance of economic growth expectations and capital flow in determining bond yields. When concerns about the stock market increase, demand for Treasuries can drive down their yields, even in inflationary conditions.

Gold also benefited from this change in conditions. The decrease in bond yields and the weakening of the dollar supported the return of the price of this metal, and gold futures reached the range of $4,200 on Friday. In contrast, shares of technology companies and artificial intelligence players continued to be affected by concerns about the cost of borrowing and the profitability of large investments.

In this way, the markets are facing two different concerns at the same time: the continuation of inflation, which could keep interest rates high for a longer period of time, and the possibility of reduced returns on technology investments, which could affect stock valuations and investors' willingness to accept risk.