Zhongshang: Short-term hawks for long-term doves Signals conveyed at the Jackson Hole central bank annual meeting.

Zheshang released a research report stating that Walsh's recent speech was overall hawkish, primarily reiterating the 2% overall PCE target and acknowledging that the financial environment is not restrictive enough. As of August 28, federal funds futures indicate a 57% probability of a rate hike in September, an increase of 22 percentage points from the 27th. The bank believes this statement is both an effort to restore the Fed's inflation credibility and a temporary concession in the face of both internal and external hawkish pressures. If this leads to financial market turmoil or if inflation decline is not satisfactory, the Fed's policy direction may quickly revert to Walsh's original path of "rate cuts, balance sheet reduction, and regulatory easing." Zheshang's main points are as follows: Walsh's hawkish stance emphasizes the PCE inflation target and the inadequacy of current financial conditions, while remaining vague about reforms. Regarding inflation, Walsh places price stability at the core of monetary policy principles, clearly stating that the 2% target measured by the overall Personal Consumption Expenditures (PCE) index is "fixed and firm," without mentioning the trimmed mean PCE. Given current data, Walsh noted that July's PCE year-on-year is still 3.7%, with about half of the PCE components rising over 3%. The inflation improvement over the past two years has been "relatively limited," and the recent data is insufficient to prove that underlying trends have substantively improved. Additionally, consumer spending, corporate capital expenditures, and the labor market in the U.S. remain resilient, and the credit market shows almost no signs of policy restrictions. His policy standard is that there must be assurance that underlying inflation is clearly moving towards the target at a sufficiently rapid pace; otherwise, the Fed "still has work to do." In terms of forward guidance, Walsh continues to downplay the direction of reform. He stated that forward guidance "has been around for too long" and can easily create ambiguity "in the name of clarity," urging market participants to track data and form their own judgments. Although Walsh clarified the principle that "underlying inflation must fall at a sufficiently rapid pace," he believes current understanding does not yet provide a clear reaction function and is working with colleagues to develop models and rules. On artificial intelligence, Walsh emphasized its importance, but the speech contained limited new information. He referred to AI as a "new variable" that could impact the economy and monetary policy and acknowledged its potential to bring about higher productivity, but mainly raised questions regarding when productivity would materialize, whether it would replace labor, and how returns on capital would be distributed, without providing quantitative judgments on potential growth rates, inflation, or neutral interest rates. Regarding balance sheet reduction, his speech did not present any new policy information. Walsh did not mention the target size of the balance sheet, the pace of reduction, or coordination arrangements with the Treasury, only emphasizing that short-term interest rates remain the primary tool for achieving the dual mandate, with specific paths needing to await the conclusions of relevant working groups. Overall, this meetings statement was hawkish, emphasizing that the PCE is the Fed's inflation target, but it remains vague on the reform of the monetary policy framework. Walsh conveyed his data analysis framework, which also reflects a hawkish stance. In terms of inflation: First, there is a focus on whether traditional indicators like PCE and CPI remain persistently above 2%. Walsh mentioned that the overall PCE has risen 3.7% over the past 12 months and has a 4.1% annualized increase over the last 6 months; the CPI is also at a relatively high level, with core PCE and core CPI both exceeding the target. Second, he focuses on the degree of inflation diffusion, using the proportion of PCE components with year-on-year and 6-month annualized increases exceeding 3%. He noted that "over the past 12 months, 54% of the prices of goods and services in the PCE basket rose over 3%, down from about 77% at the peak post-pandemic, but still significantly higher than the 32% level during the pre-pandemic twenty years. Under the 6-month measure, this proportion also reached 49%." Third, he is concerned about commodity prices and if there are new exogenous inflation risks. Fourth, he highlights inflation expectations, including medium-term inflation expectations (overall stable) and swap market inflation compensation (similarly stable). In terms of economic growth, Walsh primarily focuses on three categories of data: corporate investment, corporate profits, and private demand. First, corporate capital expenditures, measured by the annualized growth rate of corporate investment in equipment and intangible assets (about 9%). Second, corporate profits, using S&P 500 corporate earnings year-on-year growth rate (over 20%, at historical highs). Additionally, Walsh emphasized not only tracking whether profits are growing but also monitoring the "second order changes" of profit and capital expenditure growth rates and their transmission to asset prices, corporate confidence, and household income. Third, private demand, measured by the year-on-year growth rate of real consumption (over 2%), with private domestic final purchases growing close to 3% this year. Compared to GDP, which is easily affected by inventory, government spending, and net exports, Walsh believes private domestic final purchases better reflect the endogenous demand of the U.S. economy, and currently, this indicator does not show a significant cooling in the economy. In terms of financial conditions, Walsh mainly focuses on three types of data: capital market financing, bank credit, and localized industry pressures. First, capital market financing conditions, with indicators being corporate debt and leverage loan spreads (near historical lows), related market issuance scale (remaining robust), and low volatility in the stock market, indicating that firms find it relatively easy to finance through capital markets. Second, banking credit conditions, with indicators from bank loan surveys showing standards for industrial and commercial loans (at historically loose levels) and related loan balances (increasing). Walsh believes that current interest rate levels have not yet significantly suppressed credit supply. Third, he monitors whether localized industry pressures are spreading. There are certain pressures in areas like housing and agriculture, but financing and demand in other sectors remain strong. Therefore, Walsh believes that localized weaknesses are insufficient to prove that the overall financial environment is restrictive. In terms of the labor market, Walsh primarily focuses on three categories of data: unemployment, job growth, and wage growth. First, concerning unemployment, he looks at the unemployment rate, unemployment claims (4-week moving average), labor market fluidity, and localized unemployment data. He believes that the current unemployment rate and the 4-week moving average of initial unemployment claims are both low, with low fluidity in the labor market, and certain localized groups, such as recent graduates, facing some employment pressure, while overall, the economy still shows signs of full employment. Second, regarding job growth and labor supply, Walsh believes that with labor supply nearly stagnant, monthly job additions will naturally be at a lower level. Third, in terms of wage growth, he notes that although current wage growth is moderate, wages have not been a reliable leading indicator for predicting future inflation over the long term. The bank believes that the hawkish statements reflect a policy concession, and if market feedback is not satisfactory, adjustments may follow. The bank holds that Walsh's hawkish stance in this instance is a temporary concession to the markets and the hawkish veterans within the committee, representing a policy trial and error. In June's FOMC, a minority of participants already provided reasons for a rate hike, and in July, Harker, Kashkari, and Logan subsequently voted to support a 25 basis point increase, indicating increased pressure from traditional hawks on Walsh. Compared to his previous inclination toward "rate cuts + balance sheet reduction + regulatory reform," the current emphasis on the 2% overall PCE target and insufficient financial conditions reflects Walsh's temporary acceptance of the hawkish narrative, aimed at unifying the committee's stance and restoring the Fed's inflation credibility. If the feedback from a hawkish stance or even substantial interest rate hikes is not ideal, the Fed's policy direction may adjust. The capital market's response after last night's hawkish statement was not satisfactory; during the speech, U.S. stocks initially rose, and the yield on 10-year Treasury bonds fell, but subsequently reversed, with U.S. stocks closing down and long-end Treasury yields rising. The bank believes this reflects a shift in the market focus from credit repair to substantial rate hikes. If subsequent hawkish communications or actual rate hikes prove limited in improving inflation, or if higher rates generate financing pressures and significant turmoil in financial markets, the hawkish policy route may be difficult to sustain. At that time, the Fed might quickly revert to Walsh's original path, which is aimed at maintaining liquidity while reshaping the credit of the dollar and U.S. Treasuries through rate cuts combined with balance sheet reduction, regulatory easing, and coordination among multiple sectors. How to understand Walsh's "balance sheet reduction"? On April 21, 2026, during a Senate Banking Committee confirmation hearing, Walsh stated: "We must work with the Treasury Secretary to find a way to reduce the Fed's balance sheet." Walsh's approach to "balance sheet reduction" prioritizes easing financial institution regulations, with the Fed potentially reducing its balance sheet passively to avoid liquidity tightening. Market concerns about traditional balance sheet reduction (QT) stem from the end of the previous QT cycle (2019), when the Fed continued to reduce its balance sheet despite the banking system's reserve demand not being suppressed, leading to severe fluctuations in short-term rates and widespread pressure on risk assets. Similarly, in October 2025, a "private credit" risk event erupted, prompting the Fed to initiate a slight balance sheet expansion in December 2025 with its "Reserve Management Tools." The core difference of Walsh's "balance sheet reduction" is that it begins with easing financial regulation, followed by balance sheet reduction: Research led by Rajan, head of the Fed's balance sheet reform working group, points out that QE and QT are not mirror processes, and during QT, adjustments to commercial banks' balance sheets must come first, or it could lead to a "liquidity crunch," nullifying previous efforts (see previous report "What Signals Does Walsh's Reform Advisory Selection Convey?"). In addition to Rajan, Milan had already published a "User Guide for Reducing the Fed's Balance Sheet" in March 2026 as part of the Fed, providing guidance on Walsh's potential reforms. In his article, he pointed out that the policy options corresponding to "balance sheet reduction" approximately include two categories: First, lowering the demand for commercial bank reserves, including policies such as lowering the Supplementary Leverage Ratio (SLR), to guide banks to reduce reserve demand through regulatory easing; Second, lowering the occupation of non-reserve liabilities like the Treasury General Account (TGA) on the balance sheet, including adjustments to reduce the balance management target of the TGA. As for the scale of balance sheet reduction, Milan estimated the liquidity that might be "released" by 15 policy types, anticipating an overall scale of balance sheet reduction to be between $1.2 trillion and $2.1 trillion. Milan's guide aims for even more aggressive objectives, clearly stating that balance sheet reduction "will take at least a year, and may very well take several years" to initiate. Whether gold returns to the "de-dollarization" narrative remains to be seen. On U.S. 10-year Treasury bonds: The bank believes that the uncertainty in monetary policy may revert, and the probability of supply deterioration exceeding expectations is not high. Amid energy pressures, the probability of Trump-style TACO is increasing, and under the baseline scenario, long-end Treasury yields may see a slight decline in Q4. The risk of a sudden spike in U.S. bond yields lies in the unexpected escalation of U.S.-Iran geopolitical conflicts, which could possibly breach 5%. Whether gold will reverse remains to be observed. The nomination of Walsh in January 2026 led to a significant drop in gold, primarily because the market believed Walsh might drive the restoration of dollar credit. Since the beginning of this year, gold has generally returned to being negatively correlated with the real yields of 10-year U.S. Treasuries in a "dollar-denominated model." In the past two weeks, due to Walsh's unclear communication regarding the reform of the monetary policy framework and reaction functions, and further weakening Treasury credit from the Besant Repo policy, the market has temporarily observed higher real yields on 10-year Treasuries, a weaker dollar, and the strengthening of gold, showing characteristics of "de-dollarization." From this instance, Walsh's calibration of policy positions, particularly regarding "inflation," has provided some uplift to dollar credit. Ongoing observation of further statements from the September monetary policy meeting will be needed to determine if gold returns to the "de-dollarization" narrative. Risk reminders include: Unexpected escalation in U.S.-Iran conflict, unexpected decline in overseas economies.