What More AI Horror Stories? Markets Wary of Surprise Fed Rate Hike This Week, Testing Chair Warsh's Policy Style

Global technology stocks are currently facing significant selling pressure. In addition to concerns about China potentially achieving breakthroughs in advanced chip manufacturing, markets are beginning to reassess the return pressures behind the massive capital expenditures fueling the AI investment boom. At the same time, expectations that the Federal Reserve (Fed) may deliver a surprise rate hike at its upcoming meeting this week have become a key factor influencing market sentiment.

Frank Flight, Macro Strategy Head at Citadel Securities, pointed out that the Fed could unexpectedly raise interest rates by 25 basis points at this week’s policy meeting, reinforcing Chair Kevin Warsh’s policy credibility in fighting inflation and restoring price stability.

"Markets may be underestimating the extent of the Fed's shift toward a hawkish stance," Flight stated in a research report. A rate hike announcement on Wednesday would further echo Warsh’s repeated commitments to price stability and could signal a gradual departure from the previous practice of guiding market expectations through forward guidance—marking a significant end to the 'forward guidance era' and highlighting the Fed’s intent to maintain policy autonomy.

According to interest rate markets, the implied probability of a 25-basis-point rate hike this week is around 40%. Given that markets typically form clear expectations ahead of recent Fed decisions, such a high level of uncertainty is unusual. Traders have already fully priced in the possibility of a rate hike in September.

Flight argues that raising rates this week, rather than waiting until September, could have a stronger policy impact, as it would shift market expectations about how the Fed handles inflation risks.

He noted that a surprise rate hike could not only enhance the Fed’s credibility in combating inflation but also influence market behavior ahead of corporate pricing adjustments and wage negotiations, potentially reducing the need for more aggressive tightening measures in the future.

However, weaker recent employment and inflation data had previously dampened market expectations for a July rate hike. Flight contends that short-term data should not obscure longer-term trends—namely, that inflationary pressures have not fully dissipated and the labor market remains resilient.

Rising oil prices add uncertainty, testing the Fed’s policy pivot. In addition to inflation risks, developments in the Middle East are heightening market scrutiny of the Fed’s policy trajectory.

Oil prices briefly retreated after the U.S. paused daily military operations against Iran. However, due to ongoing geopolitical tensions and threats by Iran-backed Houthi militants to Saudi Arabia’s energy exports, oil prices have risen approximately 20% this month—potentially becoming a key factor pushing the Fed to maintain a hawkish stance.

If the Fed ultimately opts for a rate hike this week, it may signal a new policy phase—one where the central bank is willing to accept higher uncertainty and market volatility in exchange for greater policy flexibility. However, increased policy flexibility comes with risks. If markets perceive the Fed as rapidly adjusting policy based on short-term news, it could trigger concerns about central bank stability.

The key question now is whether the recent oil price surge is sufficient to shift policy judgment, especially since oil prices have partially retraced after their initial spike. Can this justify an immediate rate hike?

Chair Warsh will face pressure at Wednesday’s press conference to clearly explain the rationale behind either a rate hike or a decision to hold rates steady—more so than in previous public statements.

Bill English, former senior economist at the Fed, believes the central bank should make appropriate decisions based on the latest information, rather than solely avoiding market shocks. While surprising markets during a specific meeting is not unacceptable, the key is clear communication of the policy rationale.

From financial crisis to taper tantrum: Fed 'surprise' decisions have historical precedents. Looking back over the past few decades, the Fed’s more notable policy surprises typically occurred under special circumstances, with the 'surprise' itself often serving as a crucial signal.

For example, during the 2008 global financial crisis and the early stages of the 2020 pandemic, the Fed conducted emergency rate cuts to stabilize financial markets, signaling its commitment to prevent economic collapse. The series of rapid rate hikes starting in 2022 were intended to demonstrate the Fed’s determination to curb high inflation.

A common feature of these cases is that policy adjustments were not based solely on standard economic data, but rather on extraordinary actions exceeding market expectations to send a clear policy signal.

Even during major policy shifts, the Fed usually released some signals in advance.

For instance, before the Fed’s decision to hike rates by 75 basis points in June 2022, markets had gradually priced in this possibility. After Lehman Brothers collapsed in September 2008, the FOMC held an emergency meeting but ultimately chose to keep rates unchanged, as some officials wanted to first assess how financial market shocks would transmit to the real economy.

The 2013 'taper tantrum' highlighted the importance of policy communication. At the time, Fed Chair Ben Bernanke hinted at the potential tapering of quantitative easing, triggering severe volatility in bond markets and a rapid rise in long-term interest rates.

This experience influenced subsequent Fed policy thinking. Ahead of the 2015 policy meeting, then-Fed Governor Jerome Powell stated that raising rates without sufficient market anticipation could pose risks. He believed the Fed should wait until market expectations for a rate hike were clearly elevated before acting.

Now, this week’s Fed meeting will be a crucial moment to observe Chair Warsh’s policy style and reveal whether he will continue the gradual communication model emphasized by previous Fed chairs or adopt a more flexible policy approach.