Ed Dowd: The Fed Hiked Interest Rates Into A Supply Shock

Authored by Ed Dowd: Beyond the Narrative via Substack,

September FOMC Meeting: First Rate Hike Since July 2023

The FOMC did what the front end of the Treasury market (3-month T-bill) had been telegraphing for two weeks prior. On September 16 they voted unanimously to raise the fed funds rate 25 basis points to 3.75-4.00 percent. Kevin Warsh's press conference was short, blunt, and deliberately light on forward guidance. He said economic activity is expanding at a solid pace, job gains are keeping up with the workforce, unemployment is little changed around 4.1 percent, and inflation remains elevated. He argued the hike "will support a timelier return" to the 2 percent goal and "This Committee will deliver price stability." He did not submit his own dot. The rest of the Committee's median projection for fed funds now sits at 4.1 percent at year end and stays there through 2027. They mentioned inflation risks are to the upside and that labor risks are roughly balanced. Geopolitical shocks and commodity prices got a mention, but they hiked anyway.

Why Did They Hike?

The day before the meeting I posted on X that starting September 2 the 3-month T-bill yield had moved above our simple Fed-funds-rate/T-bill model. Historically the Fed follows the market more than the market follows the Fed. The signal pointed to a minimum 25 basis-point move, with 50 not being out of the question. Politics could have intervened, after all this is right before the midterms, but the Committee chose to follow the tape. They chose 25 but the T-bill market yield of 4.09 said 50 would have been the cleaner signal. The market two weeks before the decision, in my opinion, was starting to discount the energy and commodity shock as something more durable than a temporary disruption. The war is not wrapping up on a convenient political calendar. The Iranians have little incentive to resolve it before November. A war sold as a two-week excursion will be 8 months old by the beginning of November. When a supply shock starts looking structural, the front end prices a higher terminal rate even if the underlying demand picture is deteriorating. That is exactly what happened. Essentially the market priced in a very high probability that there is almost no chance of a deal until after November with energy prices remaining higher and going up.

Was Hiking The Right Move?

Hiking into a supply shock is rarely the right medicine. Rate policy cannot produce more oil or more shipping capacity. It can only crush demand. The Committee knows this...Warsh even said they cannot control individual relative prices. They hiked anyway because they decided they were not yet confident that underlying inflation was moving toward 2 percent "clearly and at sufficient speed." Fair enough as a credibility statement. The problem is the data they are using to measure the other side of the mandate.

Payroll numbers have been inaccurate for years. We have been documenting this. BLS initial prints systematically overstated job growth; the QCEW and subsequent revisions have been carving hundreds of thousands of phantom jobs out of the record. The composition of the remaining "gains" is even more telling. Healthcare has been doing the heavy lifting while manufacturing, information, finance, professional services, and retail have been losing ground. That is not a robust, broad-based labor market. That is an economy being papered over by one sector and by earlier distortions that are now fading.

Housing is already rolling over. Starts and permits plunged again in August. Homebuilder confidence is near COVID lows. Months of supply are sitting near the 2006 peak. Real house prices are declining, led by multi-family. The border tightening removed a floor that illegal inflows had put under rents and home prices. Housing is a huge chunk of CPI and of household balance sheets. It does not look like a strong demand story. Layer on the AI complex: AI and AI-adjacent names are now 40-45 percent of S&P market cap, with massive public and private debt issuance behind the buildout. Institutional investors cannot diversify away from it. Private credit is growing its defaults in the dark and seeing outflows. Enterprise buyers are starting to ask about ROI. The MSM is starting to notice all the risks. Finally China is another risk sitting in plain sight with construction output collapsing, decades of housing supply, fixed-asset investment falling, and no clean export valve left. That does not stay contained.

The Table Is Set

So we now have a Committee that just removed a dose of accommodation into a supply-driven inflation impulse while the demand side of the economy is already softer than the headline payrolls suggest. Housing is weak. The AI trade is crowded and levered. China is an acute problem. That combination has a name: policy error. Not because they raised 25 instead of 50 but because they are treating a supply shock as if it were a classic overheating demand problem and they are doing it with lagging, revised, and compositionally misleading labor data. The market has provided false signals in a rate cutting cycle before and in my opinion the Fed should have looked through the supply shock and past the blatant unwillingness of the Iranians to come to the table before the midterms. They will likely hike again another 25 bp but holding rates steady and waiting would have been more prudent.

The cycle has not changed. Easy-money periods juice activity...sometimes with genuine investment and sometimes with fraud. Tightening and then the eventual easing cycle is when the previous juice gets exposed. We have seen the movie. The current episode has its own flavor: government deficit spending, labor-force distortions, an unprecedented illegal alien sugar high, speculative AI capex boom, an opaque private credit shadow banking complex and now a geopolitical supply shock layered on top. The Fed is late, as usual. Once they reverse course and start cutting again it will be into an accelerating slowdown. It will be too late as anything they do from here will take 12-18 months to hit the real economy. The next year is going to be tumultuous.

Ultimately rates are coming down, not because Warsh suddenly turns dovish, but rather because the real economy is already weaker than the official series admit and the lagged effects of tighter policy will show up in employment, housing, and credit. When that happens the Committee will discover, yet again, that they were fighting the last war with the wrong map.

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