Merlin Weekly Macro: The Fed lumbers out of the traps

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US interest rates have been raised by a quarter point to 4%, exactly as the market anticipated. The Federal Reserve joins the European Central Bank and the Bank of Japan both of which had already begun confronting the current global inflation threat from their own different perspectives and both of which have again raised rates in this September round of policy meetings. As we will see, of the Western members among the main Strategic Drawing Rights Group of reserve currency central banks (America, the eurozone, Japan, our own and China), the Bank of England remains the stubborn outlier in believing that a direct response is not yet required. 

Four months into the job, new Federal Reserve chairman Kevin Warsh is showing he is his own man. Donald Trump actively besmirched the character and capabilities of Warsh’s predecessor, Jay Powell; in pursuit of less expensive borrowing costs and a lower dollar, Trump went out of his way to undermine the credibility and competence of the Fed. Warsh is reasserting the independent central bank’s authority. Trump cannot complain. When Warsh was sworn in, Trump said publicly that he wanted the new chairman to be “totally independent” and to “do his own thing”; with that endorsement and taking the instruction literally, Warsh is doing exactly that.

In yet another air-base tarmac press briefing, Trump this week continued to rail against what he regards as the injustice of “politically appointed” members of the FOMC board and that in his opinion the US has the “highest borrowing costs in the world” when they should be the lowest. He will not break his habit of insinuating the Fed is working against America’s interests. On hearing the news of the Fed raising the interest rate by a quarter point with the indication of further increments in the offing (one more almost certainly this year, a second possibly early in 2027), as if he had a choice without looking stupid, Trump grudgingly backed the man he had only recently appointed: “I told him, ‘you might as well vote with the board’”. How long this qualified support for Kevin Warsh lasts from this mercurial and volatile president is anybody’s guess.  But despite those public injunctions to be independent, it is abundantly clear that while it refuses to heed his exhortations for loose monetary policy, Trump remains convinced that the Fed is a subversive agency.

The US economy remains buoyant though less exuberant than a year ago. Year-on-year inflation-adjusted ‘real’ growth in the second quarter was 2.1%. However, it is an uneven distribution. Economists’ estimates vary widely as to the effect of technology investment on overall US economic activity: for example, global investment bank ING reckons that in 2026, the ‘artificial intelligence’ chain in all its guises will contribute a third of overall momentum. The Federal Reserve finds ascribing a precise value to be difficult: it describes investment in the supporting infrastructure (electricity generation and the grid, chip foundries, data centres etc), the direct investment in technology architecture (software & services) and the efficiencies gained from the applications of artificial intelligence and other technologies, as having a “significant” effect. The AI-generated response to a simple Google enquiry puts a best-guess approximation between 25% and 50% of current GDP growth being attributable to “technology”.

Given its significance, even if hard to quantify precisely, the reliance on technology as the major catalyst behind headline US growth has been brought into sharp focus. Last week, we reported the Anthropic boss predicting AI could destroy humanity within 10 years. Far from being dismissed as hysterical and a heretic, as though being unburdened of a great and horrible secret now that one of their ilk has said the unsayable, many of his fellow tech leaders have broken cover with him heeding Senator Bernie Sanders’ call to “SLOW DOWN!”. The King is of the same mind. They welcome guard rails and fail-safes being put in place that maintain human supremacy over what the CEO of Microsoft AI dubbed the new rival “silicon species”: crudely, the ability to pull the plug on this potentially monstrous automaton before the monstrous automaton extinguishes us. With justification, Trump insists the technology arms race is one the US simply cannot allow China to win. The question being raised is, if the rate of investment measured in trillions rather than billions of dollars is slowed, what deceleration in headline US growth might be anticipated and over how long?

In his press conference, Warsh referenced the Fed’s official inflation barometer, the Personal Consumption Expenditures index. Registering growth of 3.7%, nearly double the Fed’s mandated 2% core inflation target, that acceleration in PCE was itself sufficient to warrant an increase in interest rates to 4%. “The plain fact is that inflation is too high and has been for too long”, said Warsh. Looking forwards rather than backwards, he will be only too aware of the potential impact created by the recent resurgence in commodity prices directly linked to the expanding and enduring conflicts in the Gulf and Ukraine/Russia. Covering the spectrum of commodities from energy to foodstuffs and raw materials, the broad global commodities index is already up nearly 50% so far this year. Shipping and freight container costs and maritime insurance premiums, particularly for cargoes transiting through the Gulf region, the Arabian Sea and the Red Sea, have rocketed. 

Bank of England: “Not much to see here. Move on, little people”

The Bank of England’s interpretation of the same global data is strikingly different from its peers. By a 6-3 majority, the Monetary Policy Committee voted to hold the Base Rate at 3.75%. While noting the rise in UK inflation to 3.1% in August and all the factors discussed above about commodity prices, the Bank takes the relaxed and complacent view that little has troubled the consumer directly: in its technocratic, detached language, “There has been little evidence so far of material second-round effects in price and wage setting”.

This rather condescending dismissal loses sight of a fundamental truth for the consumer: inflation is the compound interest rate for nominal prices. In the period spanning January 2020 (i.e. pre-Covid and pre-Ukraine) and August 2026, the mean average inflation rate in the UK was 4.2%; that includes the hiatus when the year-on-year rate peaked at 11.1% in October 2022. However, in nominal terms, that translates into prices increasing by 35.1%. That neatly differentiates “inflation” from the “cost of living”. If the headline in the Daily Telegraph proves correct that £2.30 for a litre of diesel is possible by Christmas, 55% more expensive than in late February before Trump went to war, some might be tempted to tell Governor Bailey where he can stick his second-round effects.

With higher financing costs for households (e.g. mortgages and car financing) and businesses reflecting elevated fixed income yields, Bailey is again conceding that the bond markets are doing the heavy lifting in place of the central bank. With a much more hawkish assessment of the inflation outlook, the markets are in control of monetary policy through bond yields rather than the Bank through the Base Rate; the Bank has effectively abrogated responsibility. 

Opening up an interest rate spread particularly against the dollar, the Bank’s decision risks weakening sterling. The UK has a chronic negative balance of payments: we import far more than we export, including oil, gas and food. A weaker currency makes imports more expensive (as well as exports being less competitive). If the Bank insists it is mindful of the risk posed by global commodity prices, knowingly weakening our currency potentially adding to the inflationary pressure seems a perverse way of mitigating against it.

For what it is worth, the market hasn’t entirely given up on the Bank and is currently assuming that when the Old Lady finally stirs her stumps, 3.6 interest rate rises (can you have 0.6 of a rate rise? Clearly not---we just report the facts!) are assumed between October and July. The implication is a new terminal rate of 4.65% against the 3.75% prevailing today. Bailey says that an interest rate rise is “likely”; unlike the Fed, the ECB and the Bank of Japan, it is not clear what else his committee is waiting for. Why not just get on with it?

What happens next? Best ask Trump and the IRGC

10-Year government bond yields have recently tested 5% in the US, 3% in Japan, 5.5% in the UK and 3.5% in Germany, all multi-decade highs. As some immediate pressure is alleviated from the oil price as Saudi reports the damage by the Houthi attack on its Persian Gulf-Red Sea terrestrial pipeline is not as bad as feared, bond markets have expressed relief. Yields have retreated. In the UK, the Bank announced a technical rejigging of its bond sale programme; while certainly not abandoning the object of clearing the decks of all the government bonds that it acquired during the process of quantitative easing, a more pragmatic approach was met with approval. 

Where yields go from here depends on several factors including the global disruption created by the new, emerging El Nino weather system brewing in the Pacific. However, the biggest determinant remains the stalemate pervading the US-Iranian conflict. It is taking on the 21st Century characteristics of medieval siege warfare. Trump seems prepared now to sit it out and wait to see if his economic sanctions noose eventually throttles the Iranian economy to the extent the regime expires or surrenders, he does not care which; the Iranians, acting in concert with the Houthis, are equally determined to tighten their own grip on the pressure points in the Strait of Hormuz and the Bab El Mandab Strait that they know choke the global economy, while simultaneously wanting to humiliate Trump by portraying him as weak and a loser ahead of the US mid-terms.

The siege’s symptom is inflation. The key questions are: what is already inevitable? What could push it higher? How long might it endure? The consensus prognosis remains that the effect is less likely to be as great as in 2021-2023 in the aftermath of Covid and the outbreak of hostilities in Eastern Europe; what is obvious is that it is likely to be worse than was anticipated early in the US-Iranian conflict when the received wisdom was it would all blow over quickly.

Neither we nor anyone else knows the answers; as well as rolling with the punches, the volatility in commodity prices and bond yields is a direct result of investors presuming to know the answers or second guessing the outcome based on what is rational from their own perspectives. But markets are not controlling events. The reality is that only Donald Trump and the leadership of the Iranian Revolutionary Guard Corps can offer any greater insight. Asking either will get no answer from the latter and not much sense from the former.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.