Kevin Warsh, the new chair of the Federal Open Market Committee (FOMC), has faced economy-related turbulence during his first few months—from his colleagues in the form of three dissenting votes at last month’s meeting, and from the bond market in the form of rising interest rates. Warsh has argued in favor of providing less guidance to the markets about the FOMC’s assessment of the future course of interest rates, making the claim that this will allow the Fed to get an “unfiltered and direct” set of signals from the markets.
Even while expressing a desire not to influence market expectations, the new chair may have done precisely that during his press conference after the FOMC’s July meeting. In his opening statement, Warsh focused on two points that suggest he may be revising up his estimate for the equilibrium real fed funds rate (sometimes referred to as r-star or r*). He observed that real interest rates have risen significantly in recent weeks.
The yield on Fed’s real 10-year constant maturity series (derived from the inflation-linked bond market) has risen over 50 basis points in the past three months to slightly more than 2.4%. The nominal 10-year yield is now at 4.7%, its highest level since 2007 outside of a brief period in the fall of 2023. Relatedly, Warsh noted that capital expenditures (capex) related to AI have been providing an extraordinary boost to growth and are laying the groundwork for future acceleration in productivity. If this surge in investment is indeed the dawn of a new era of faster growth, the economy’s equilibrium real interest rate will be higher.
U.S. Economy 101: SEP and reduced savings
It should be noted that FOMC members have been boosting their estimates of the long-run equilibrium fed funds rate in recent years. In the Summary of Economic Projections (SEP) released in June, it stood at 3.1%. Four years earlier (in the June 2022 SEP), it stood at 2.4%. The FOMC has been grappling with this question for some time. It is unclear that this particular issue has any strong implications for the near-term path of monetary policy. It is important for the medium-term outlook.
For the near term (the September 15-16 meeting), the three dissents in favor of a rate hike may be a stronger signal. The core inflation and job growth numbers over the next two months will also matter. The unemployment rate has been approximately stable in the past year, and core inflation (as measured by the CPI) has fallen to 2.6% from 2.9% a year ago. It is unlikely that the Fed will tighten in the near term as long as the data remain consistent with those trends.
As is often the case, there are risks in both directions. Consumer spending grew 3.2% in the second quarter. This is a surprisingly strong result given the energy price shock that households had to deal with in the quarter. Many households have maintained spending levels by drawing down savings. The savings rate has dropped to 2.7% in June from 4.6% in June 2025. Coping with higher prices by reducing savings is not a strategy that can be continued indefinitely. At some point, consumption growth is likely to slow. However, this could be offset by the ongoing surge in capital expenditures related to AI, which shows no signs of abating.
The outlook for inflation remains murky. The Supreme Court’s ruling setting aside some of the Trump administration’s tariffs has led it to impose new ones under different legal authority. These new tariffs will undoubtedly be challenged in court. Other indicators of inflationary pressure are not providing clear signals. Measures of medium-term inflation expectations remain low and stable. Measures of wage inflation show little change during the first six months of this year compared to last year. Inflation does remain somewhat higher than the Fed’s target. The three dissents at the FOMC’s last meeting indicate that this status quo is unacceptable to some on the committee and that they are impatient for tangible progress. In the absence of such progress, they and possibly others are likely to vote for a tightening of policy when the FOMC meets again in September.
The bond market has taken all this into account. Warsh’s disquisition on capex and the possibility of a higher equilibrium fed funds rate might have reinforced the case for higher interest rates.
