What happened is one of the clearest examples of how markets work.
A central banker stood in front of a room full of bond traders and paraphrased John Lennon. “Give disinflation a chance,” he said. We can wait one meeting.
And within a few hours, the Dow had climbed more than 600 points. The S&P 500 was up over 1%, and the Nasdaq had gained 1.4%. Bond yields, which had just hit multi-year highs the day before, turned lower across the entire curve.
Christopher Waller is a member of the Federal Reserve's Board of Governors. In other words, he is one of the people who votes on interest rates. And statements like these are watched under a microscope.
So what did he tell Reuters? He said that if the data over the next two weeks continues to move in the same direction, he would support keeping interest rates where they are.
He acknowledged, of course, that inflation is still “significantly above” the Fed's 2% target. But he also said something the market had been waiting months to hear: that we are finally seeing signs of disinflation.
And he backed that up with numbers. The three-month annualized inflation rate, using the measure preferred by the Fed itself, has fallen from 4.76% in February to 3.05% today.
“Yeah, but wasn't inflation 3.7% in July?” you might be wondering. Correct. Waller, however, says that annual figures are not the best guide to where inflation is today. He believes the underlying trends are better than the headline numbers suggest.
He added two more points. First, tariffs ultimately have not passed through to prices as much as feared. Second, some service prices that are not directly measured but estimated may be pushing the numbers higher. And revisions to the calculation methodology are expected to bring down measurements from previous months.
And this is where things get even more interesting.
Just one week earlier, Fed Chair Kevin Warsh had said something completely different at Jackson Hole. He argued that the softer monthly readings “do not tell me that the underlying trends have materially improved.” He also added, “we have work to do.”
The market interpreted that as a clear signal that interest rates might need to go higher, and priced accordingly.
Now Waller comes along and says essentially the opposite. His argument is very simple: “What does it cost us to wait one meeting? A 25-basis-point hike right now is not going to bring inflation down to 2%.”
And to understand just how divided the Fed is at the moment, consider the July vote. It was 9 to 3 in favor of waiting. Three people, Hammack from Cleveland, Kashkari from Minneapolis, and Logan from Dallas, wanted a hike. That was the most dissent in a single meeting since 2016.
The clearest reaction, however, did not come from stocks. It came from bonds.
The 10-year US Treasury yield fell more than 4 basis points, to 4.748%. The 30-year yield fell more than 3 basis points, to 5.233%. And the 2-year yield, which tracks Fed moves more closely, dropped more than 5 basis points, to 4.332%.
And pay attention to something important: bond prices and yields move in opposite directions. When the yield falls, the price rises.
“Why should I care about the 10-year?” you might be wondering. Because mortgage rates, car loans, and credit card rates are priced off it.
And this is exactly where the stock market celebration comes in. As yields rise, a boring government bond offering nearly 5% starts to look very attractive next to stocks. So when yields turned lower, stocks caught fire, with the Dow having its best session since August 4.
The Fed's policy rate is currently in the 3.50% to 3.75% range. The next meeting is on September 15 and 16. And the probability of a hike, according to CME FedWatch, fell from above 60% to around 50%. In other words, it's now… a coin toss.
Of course, there is one big “but.”
This entire rally rests on one condition. Waller did not say, “We will not hike.” He said, “We will not hike, IF the data cooperates.” And he made it clear that policy is currently only mildly restricting demand, so it may not take much of an acceleration in inflation to push the Fed toward tighter policy.
