Inside the Federal Reserve: Policy, markets and what's next

Disclosures: The views expressed are solely those of the authors and do not necessarily reflect the views of First Citizens Bank and Trust Company or any of its affiliates. This material is for informational purposes only and is not intended to be an offer, recommendation or solicitation to purchase or sell specific investment strategy, any security or insurance product, and should not be construed as legal, tax or accounting advice.

Thomas: I'm Thomas O'Keefe, Managing Director of Portfolio Strategy.

Phil: And I'm Phil Neuhart, Head of Market and Economic Research.

Thomas: And today, we're going to be talking about the Federal Reserve. You hear us talk about the Federal Reserve a lot. We talk about inflation. We talk about employment markets. And we have a new Fed Chairman, Kevin Warsh. And so today, we wanted to go a layer deeper and talk about the Fed and where they're taking us.

Phil: And this timing is really interesting. We're getting a lot of questions from clients around the future of rates, inflation and how the Fed might respond under a new chairman. And to talk about that, we've asked our market and economic research analyst, Blake Taylor, to join us today. Blake, thanks for being here.

Blake: Oh, my pleasure.

Phil: So, Blake, our subscribers see you constantly. You record In Brief regularly, our Monday week-ahead outlook—not to mention recent monthly webinars in which we dive deep into the market and the economy. You always do a fabulous job, by the way.

Blake: Oh, thanks.

Phil: So what people may not know is your specific expertise regarding the Federal Reserve. Not only have you spent a significant amount of time of your education and career studying the Fed, but you have spent time working at the Federal Reserve. What is it like at the Federal Reserve?

Blake: Well, Phil, not only did I work there, I was actually a member of one of the Fed's lesser-known committees—also one of the worst-performing—and that was the Fed softball team.

But directly to answer your question, what it's like there, I think I'd say two things. First, it's staffed with a huge number of very talented, skilled people who care a lot about outcomes for the American economy. And most of those are very well-educated PhD economists. The Fed actually employs about 900 PhD economists, about half in the board in Washington, DC, and half spread throughout the Federal Reserve system across the country. So there's no shortage of really good people, really highly trained people, who really care.

Phil: That's fascinating. I don't think the average American would know that, just how highly educated the Fed is. This is not—sometimes I think we imagine a group of bureaucrats—this is really a group of academics.

Blake: Well, to be clear, you can have academics who are bureaucrats, and that's kind of how I'd describe the Fed. But just despite that or maybe because of that, it has a very academic culture, very theoretical, and I think that that does a lot of good things.

There's very few small mistakes that are made. Everything is done very properly and correctly and by the book, but I think that part of that means that things move sort of slow and it can take a while to get really important analyses and conclusions exactly where they need to be.

And I think, honestly, we saw a little bit of that in the last few years of things moving maybe a little bit too slow and not getting the exact right answers on forecasting inflation. But it's not from a lack of trying, I can tell you that.

Phil: Yeah, so maybe not the most agile of organizations. Why don't you give us a little bit of a history lesson? What does the Fed do, and how did we get to the current institution?

Blake: Yeah. Well, so the Fed is, of course, the US Central Bank, and it's mandated by Congress to try to deliver two things for the American public: maximum employment and stable prices. And it has only a few tools to go about doing that. And, yeah, I think as quickly as we can, going through the Fed's 113-year history is maybe a good way to figure out where we've arrived.

So the Fed was born in 1913 out of the wake of a series of financial crises and banking panics in the late 1800s that culminated in the Great Panic of 1907 that led a lot of the titans of industry and government officials to say, "We have to figure this out." And they created a Federal Reserve system that spanned the entire country, headquartered in DC and largely run out of New York City.

And it had its first test throughout the early 1900s and didn't do too well in the Great Depression. That's when people were less concerned about what the return on their money is and they were just looking for a return of their money.

And what we saw was the Fed got reorganized, and it didn't quite get its full identity as we know it now probably till about 1951. That's when the Fed and the Treasury agreed that after World War 2 when the Fed had—a lot of its function had been financing the war—they agreed, "Alright. The Fed's going to be independent now, and it's going to independently run monetary policy."

And it's after that and the decades after the Fed really gained its footing as the modern institution that we know now. And Fed Chairman at the time, William McChesney Martin, popularized this term, this analogy of the punch bowl. And this is how the Fed managed the business cycle. Right when the party was getting maybe a little too hot, that's when the Fed would come in and remove the punch bowl.

And that's the way that the Fed tried to manage the business cycle throughout most of the rest of the 1900s. And the best example that we can give of that is in the late 1970s and 1980s when we had the multiple oil-price shocks of the 1970s, high inflation, high unemployment, and new Fed Chairman Paul Volcker came in and tightened the money supply so much that interest rates rose to about 20% in 1980, 1981, leading to really high unemployment.

And it was in this period where—yes, that that did bring inflation down—but it was with tremendous consequence. People were so unhappy about it. You had farmers who drove tractors into Washington, DC, and parked them outside the Fed board. You had homebuilders who sent two by fours in the mail to Paul Volcker's office trying to get—

Phil: Excess lumber.

Blake: Trying to make a point. But it was in this period, thanks to Chairman Volcker, that the Fed really built the credibility that it's had since then. But to really understand where we are now, I'd say there's probably a third chapter that we need to understand, and that's in the last 15 or so years after the Global Financial Crisis. Of course, in 2008, 2009, the Fed under Chairman Bernanke went to extraordinary measures to borrow the way that our equity colleague, Kyle Murphy, puts it. Ben Bernanke saved us from bread lines is what I've heard Kyle say, but it wasn't for free. The Fed transformed itself as an institution. It went to great lengths. It started buying assets.

Phil: Expanding its balance sheet, as you'll hear people say.

Blake: And really tested the limits of just how much one organization can try to save not just the US economy, but the global economy. And we saw it again in 2020. Under Fed Chair Powell, went to enormous measures to stabilize the economy and the market in March and April of 2020.

And to get back to your question of what does the Fed actually do, in my opinion, I think where we are now is we have a Fed at a crossroads of "Is the Fed just in charge of trying to manage price stability in the US, or are we treating it as this institution where we want it to deliver all of the economic outcomes that we want?"

And I think that's the debate that we're going to see in coming months ahead is what do we actually want out of this institution?

Phil: And so before we turn to the new chair, one thing you alluded to, but maybe you could dig in just a moment on, is the Fed's dual mandate. When did that come about? How did it come about? And what is it?

Blake: Yeah. Congress rewrote the Federal Reserve Act in 1977 to say "Your specific role is to deliver price stability, maximum employment and moderate long-term interest rates." And people look at two of those three and they call that the dual mandate. And over the decades since 1977, that has been what the Fed has focused on—sometimes more focused on price stability, sometimes more focused on employment.

That was a big thing that happened in 2020 was the Fed came and they said, "We are going to squarely focus on employment. Employment has been too soft in the decade of the 2010s. We want that before price stability."

Unfortunately, that was not the best of timing. That's when inflation started to spike, and now we're kind of paying the cost for that, and that's exactly where we are now. We have inflation above 3%. It's been above target for over 5 years.

Phil: The target's 2%.

Blake: The target of 2%, but unemployment has been stable at around 4.3% for several months, and now we're at the question of "Which of these priorities are we going to elevate?"

Thomas: So the challenge is really when these two measures are conflicting each other, correct? How do they marry, whether it's either prices are stable and unemployment is not or the reverse of that, having to make decisions based off of that?

Blake: Well, for much of the second half of the 1900s, economists thought there was a clean relationship between what you're describing. It was called the Phillips curve. There's a direct trade-off between inflation and employment. When employment is running too hot, you're going to get inflation, and a way that you can bring that inflation down is moving along that curve. People no longer really think that that relationship is particularly strong.

Phil: The Phillips curve may just be a jumble of dots. Not really a curve.

Blake: That's certainly what the graph looks like these days. But, Thomas, also I think that the world just seems more complicated, at least in this decade, if not it always has been. There are a lot of other imbalances that we care about and that the Fed cares about other than just those two, and none of the Fed's tools actually directly affect one of them. There's no dial that brings employment up and down. There's no dial where you directly change inflation.

The Fed has very limited tools that it can use to affect the broader markets, to affect interest rates at different points of the curve, but mostly at the front. Phil, it's one of your favorite points to make. The Fed does not control long-term interest rates, it controls overnight rates.

But more broadly, I think that people have gotten used to the Fed affecting broad financial conditions. Fed policy can—when it's loose or as the Fed said accommodative—that's going to be favorable to equity markets. It's going to allow for multiples to expand.

So when things start to get overheated, you're faced with the question of "We have this one, very few tools, mostly one, of affecting the shortest-term interest rate. If we're going to dial that up, that's not just going to bring inflation down on its own. That's going to go through the whole system. That's probably going to bring equity prices lower. It's going to raise interest rates. It's going to affect housing. It's going to affect the entire economy."

Phil: That's right. But these are blunt tools, and sometimes there's unintended consequences with the Fed using these fairly blunt tools to drive the economy and deal with that tension of the dual mandate. So speaking of that tension, we have a new chairman, Kevin Warsh, coming on board. Meeting is imminent. His first meeting, I should say.

Tell us what you know about the new chairman and about this transition, and obviously he's coming at a very interesting time for the economy.

Blake: New Chairman Warsh has some very—an interesting combination of experience. On the one hand, he has firsthand experience managing this institution. He was a Fed governor. The Fed is comprised not just of a chairman but of seven governors in Washington, DC, and then 12 regional Fed presidents throughout the country.

Kevin Warsh was one of these governors based in Washington, DC, during the Global Financial Crisis, and he was largely responsible for mediating between the Fed and Wall Street at some of the most complicated times in the history of both of those institutions.

Phil: Really a great time to learn as a Fed governor, I can imagine.

Blake: So he's bringing in tremendous experience, but he also is bringing in some really solid financial market experience. He worked for a major investment firm out of New York City in the years after he left the Fed, and then also he has spent a lot of time studying the Fed.

He's been—it almost seems—preparing for this role for many years, and I think it's going to be really interesting to see where that goes. I had the pleasure to meet him a couple years ago, and I can tell you he's someone who really cares about monetary policy, about the Fed and about delivering the best outcomes that that institution can for the public.

Phil: So, look, we don't know what impact he might have as a new chairman, but new chairs do tend to put their fingerprints on things. Where might he have a different perception of the role of the Federal Reserve and the Federal Open Market Committee relative to, kind of, the recent string of Fed Chair Bernanke, Yellen and, of course, Powell? Is there a potential for shift from a transparency perspective, balance sheet? What are your thoughts there?

Blake: Yeah. I think that the Fed might be poised for one of the bigger shakeups that we've seen in a few decades. The Fed, kind of as I was alluding to at the beginning of our conversation, is very bureaucratic. It has a long institutional history, and it's gotten used to doing things a certain way.

And a lot of those have gone extremely well, of course, but a lot of them maybe are due for a shakeup. One in particular where we might see him first attack things is on the way that the Fed communicates with the markets and with the public. Since the financial crisis, the Fed has, I might say, in my opinion, overcommunicated.

Phil: Dramatic increase in terms of the amount of communication.

Blake: And maybe some of that was warranted. You know this better than me about how Greenspan, the chairman in the 1990s and early 2000s, used to communicate.

Phil: The idea of Greenspan having a press conference after every FOMC meeting would have just been absurd.

Blake: People used to look at the size of his briefcase, I think.

Phil: Yes. One of the Fed's tools—when you think back to an old hand like me when I started—one of the Fed's tools, honestly, was not being transparent and being able to surprise the market by raising or cutting rates. Now, it is very well-communicated to the market what the Fed's going to do before they do it. And that has really been a shift over the last 20 years.

Blake: Yeah. And what the Fed has called that is actually it thinks of it as one of its actual tools. It's called forward guidance. We're going to tell the market what we're going to do in advance so the market has time to react to it. That's why when the Fed changes rates, like when it lowered rates in 2024, the market had already adjusted to that reality. So by the time in September when the actual rate change occurred, there wasn't much for the market to do.

Phil: Think about the summary of economic projections. That is a new document created by the FOMC showing their forecast, but one of the forecasts they show is the federal funds rate, which is quite a dramatic shift in terms of how the Fed communicates to the marketplace.

Do you think Chair Warsh could make material changes to things like the press conference, the summary of economic projections? Again, we don't know, but is your sense that that is a possibility?

Blake: I think that that is where we're going to see some shakeup. It's probably going to take some time. I don't think that it's in anyone's interest to shake these things up overnight, especially as he's trying to win over a consensus of his new colleagues. But I think that it's been the consensus for quite some time, including as we've heard from former Fed Chair Powell, that what you call the dot plot—the summary of economic projections—doesn't really communicate what they want to. So yes, I do think that that's an area where we're ripe to see some change.

Also, I think it's possible that Chairman Warsh might try to bring in some new thinking on both measuring and forecasting inflation. Unfortunately, that has been a real shortcoming, not just of the Fed and the people who work there, but really of all of us in this decade has been understanding inflation, let alone being able to anticipate it.

That was one of the—as some people have called it—one of the biggest blunders of the institution in its history was the inability to foresee and properly respond to the inflation after the—

Phil: Transitory inflation will live in infamy. Let's turn a little bit more to monetary policy. We have seen a major shift in expectations around the federal funds rate so far this year. We came into the year with fed funds futures pricing one or two cuts back half of the year. We were a little bit skeptical of that, but now with of course the oil-price shock due to the war in Iran and really price pressures from that, now fed funds futures are pricing a hike between now and the year end. By the way, we're somewhat skeptical of that as well. But what's your sense in terms of the actual outlook for monetary policy in the next back half of the year?

Blake: The Fed seems to still be on hold. In my view, the Fed needs to raise interest rates when the economy is overheated. And inflation is above target, that's for sure. But part of why it has reaccelerated from 2.5% to 3% to 3% to 3.5% is from one of the purest forms of supply shock out there—and that is an oil supply crunch.

Needless to say, the Fed cannot change the amount of oil flowing through the Strait of Hormuz by changing the federal funds rate.

Phil: I would I add memory chips to that list as well. There are things outside the Fed's control.

Blake: And these yes. That’s probably the other half, and may maybe that one has a little bit more credibility for why the Fed needs to think about an economy that's running a little bit hot. I'm probably not the best one to give the answer, but my guess would be that if the Fed raises the federal funds rate, that's probably not going to change demand for computer processing and building out of the AI complex.

Phil: Yeah, I think we're outside of the things that the Fed can impact. So we mentioned the tension, and just to dig in on this a little bit more, the concept of—we had the Fed cut in 2024, we had them cut in 2025 and now they might hike.

Inflation's running above their target, but that was true before the war in Iran is the truth, and the job market is okay. We just recently had a decent jobs report, but clearly still kind of a lower-higher, lower-fire environment. So what is your instinct? If you're the new chair coming in, what are you thinking in terms of that dual mandate and then rates?

Blake: Yeah. Well, let's take both sides of the dual mandate. Honestly, I've been a little surprised at how quickly the financial market consensus and the commentators, and even Fed policymakers have quickly changed tune to argue that the labor market is rebounding.

I think that these things move in very big and slow waves. And actually, some really interesting and important research emerged this spring where some academics looked at 94 different labor market indicators, and they were able to identify a broad pattern that visually looks exactly like what's happened to the labor market: peaking in 2021, starting to soften quickly in 2022 and just gradually softening, getting back to normal ever since then.

There's not big changes that happen on a month-to-month period in that kind of trend, and we can see that by looking at many of those 94 indicators, not just the number of jobs created according to the Bureau of Labor Statistics and the national unemployment rate, but what's happening with small businesses? Small business job growth has been much softer. Wage growth at workers who are employed by small businesses on an inflation-adjusted basis is negative.

There's a lot more that needs to be considered rather than just those headline numbers.

Thomas: But to your point earlier, the Fed doesn't control a lot of the factors that go into what you just said right there. There's a lot of other political inputs, business inputs, localized market inputs, trade inputs.

Phil: The AI revolution.

Thomas: Exactly. That are going to impact, you know, more so than an interest rate or a Fed balance sheet, right?

Blake: Yeah. I think, Thomas, you literally hit the nail on the head with that. You cannot dial up and down something like employment growth and wage growth just by tinkering with that, right? And also, as we said on the other half of the mandate that we just talked about, Phil, is with inflation. That's not how it works either.

But a third thing that I would bring into mind here, bring into the discussion here, is that even though you mentioned the Fed's dual mandate, Phil, of maximum employment and stable prices, there is a third implicit mandate that they've had since the Global Financial Crisis, and that's financial stability.

And I think that that is throughout the Fed's decision-making is how is this going to affect markets. That's what we saw in March of 2020. That wasn't just about inflation and employment. That was about financial stability.

So that's something that as the Fed is thinking about, I think that this summer, as the Fed is contemplating raising rates, that's something that they're going to have to think about. How's that going to affect equity markets? How's that going to affect private credit and commercial real estate? How's that going to affect the broader financial system?

Phil: Well, you always have this issue of, yes, the dual mandate, the growth side is full employment, but a negative wealth effect can hurt employment. And the Fed does have to think about those follow-on impacts.

Thomas: Yeah, so why do our listeners care is actually the ultimate answer to all of this, or question to all of this, I should say, is a new Fed chairman, potentially different policy—or at least a different way of thinking about it—changing financial market situations. Should anybody listening to this right now worry about it?

I don't want to say care about it, but should they be overly concerned about headline news with the Fed? Or is it more to the point you made earlier where this is a big, slow machine that is going to take time with lots of factor inputs. How should we be thinking about that?

Blake: The Fed is not the only game in town. That was something that maybe used to be the case. I don't believe that that's true anymore. Should we not pay attention to the Fed? Absolutely not is that the case. We very much still need to pay attention. But in addition to focusing on the short-term interest rates that the Fed sets, we need to be focusing on all of the other major themes that are affecting markets.

What is happening with the AI CapEx buildout and with mega-cap tech? Could anything be more important than that today? What are other risks that are going on? Are we going to get energy supplies moving back through the Persian Gulf and into the open market?

Thomas: Look at trade, tariffs, what's going on geopolitically.

Phil: Still a theme. Absolutely.

Blake: So, Thomas, I would say I hope that this conversation has been helpful and interesting to people to learn more about the Fed, but thanks for bringing that back to Earth because, yes, we are going to follow every single thing that the Fed does to better understand it, but I think it's important in 2026 to have that context that the Fed is not the only game in town, and it's one of many big factors that we need to follow.

Thomas: Yeah. And then ultimately, this gets input into our portfolio construction process and how we think about allocating our clients' capital.

Phil: So that's enough of serious conversation, Blake. What we really—and all of our listeners—want to know is what position did you play on the Fed softball team, and what was the team's record?

Blake: Well, unfortunately, we lost every single game that we played except for one where we were tied. And unfortunately, we had to end the game early, so we'll never know what happened because President Obama was coming to land his helicopter across the street.

But I think that perhaps we were better skilled at the social hour after the games than actually in the athletic events themselves.

Thomas: So much fun. Well, we're going to have to get our own First Citizens softball team going. Blake, thanks so much for being here. We really appreciate it. Hope everybody got a lot out of this, and you'll be hearing from us soon.

Blake: Yeah. Thanks for having me.

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