The Federal Reserve Is Never the Referee!

Walsh's "market self-governance" narrative is creating new uncertainty.

The Federal Reserve kept interest rates unchanged at its July Federal Reserve Meeting, but Chair Walsh's remarks at the press conference sparked widespread controversy in the market. He claimed that as forward guidance fades, markets have learned to "play the game rather than watch the referee," with financial conditions tightening spontaneously through market mechanisms. However, critics argue that this narrative is fundamentally untenable—the Federal Reserve has never been a referee but one of the most important players on the field, and changes in communication strategy cannot alter this fact.

The meeting saw a rare three dissenting votes, with regional Fed Presidents Hammack, Kashkari, and Logan all supporting a 25 basis point rate hike. After the meeting, the US Treasury yield curve steepened significantly, with the 30-year Treasury yield briefly surpassing 5.20%, while the two-year yield fluctuated violently after the press conference, initially dropping 10 basis points before narrowing to a 4-basis-point decline. Institutions such as Goldman Sachs, Barclays, and Nomura generally believe that the Federal Reserve is tacitly allowing the bond market to replace official rate hikes, but this strategy carries the risk of unanchoring inflation expectations and exacerbating policy volatility.

Walsh's Core Argument: Let the Market Do the Federal Reserve's Work

At the July Federal Reserve Meeting press conference, Walsh interpreted the significant rise in long-term and short-term US Treasury yields since the previous meeting, characterizing it as a positive signal. He stated that during the intermeeting period, "market attention focused on real data and real economic dynamics, with prices reacting to information in real time; the reduction in forward guidance may be a factor."

He further stated that market participants are learning to "play the game rather than watch the referee," which he views as progress, noting that "the central bank does not always need to be the center of attention."

This statement was not unprecedented. Walsh had conveyed similar signals after the previous meeting, but this time his wording was clearer and more emphatic. The underlying policy logic is that if the Federal Reserve possesses credibility and inflation risks rise, the bond market will spontaneously sell off, causing real and nominal interest rates to rise and financial conditions to tighten, thereby marginally cooling the economy—all without the Federal Reserve explicitly signaling a rate hike.

Why the "Referee Theory" Is Untenable

Robert Armstrong, a columnist for the UK's Financial Times, directly criticized Walsh's framework, arguing that it is "fundamentally wrong." Armstrong pointed out that Walsh's core assertion is that before he took charge of the Federal Reserve, market reactions to economic data were "mediated" by expectations of Federal Reserve policy, whereas now this mediation has been removed, allowing the market to respond directly to "real economic developments."

However, this is far from reality. The Federal Reserve sets short-term interest rates, and any market participant betting on the direction of short-term rates must necessarily form judgments about the Federal Reserve's next move. Regardless of the length of the Federal Reserve's press release or the substantiveness of the Chair's answers, this logic remains unchanged.

As former New York Fed President Bill Dudley recently wrote, "Financial markets price not what the Federal Reserve should do, but what they think the Federal Reserve will do." Armstrong's conclusion is that the Federal Reserve is not a referee but a player, and a very important one at that. Adjustments in communication strategy cannot change this basic fact.

Potential Risks of "Market Substitution for Rate Hikes"

Walsh's strategy also faces inherent contradictions in practice. The boundary between "letting the market do the Federal Reserve's work" and "the market forcing the Federal Reserve's hand" is extremely blurred. If the market spontaneously tightens financial conditions and the Federal Reserve subsequently chooses to hold steady, the Federal Reserve is effectively easing financial conditions through "inaction"—because the market's expectation of tightening has been proven false.

Market movements following the July meeting provide preliminary evidence. The two-year yield fluctuated violently after the press conference, ultimately declining only slightly, reflecting high uncertainty regarding the short-term policy path; meanwhile, the rise in the 30-year yield may indicate that long-term inflation expectations are rising—the emergence of this signal occurred precisely against the backdrop of three committee members voting for a rate hike, which does not constitute strong endorsement of Walsh's credibility.

Analysts at Goldman Sachs, Barclays, and Nomura all believe that the Federal Reserve is currently tacitly allowing the bond market to substitute for official rate hikes, but this strategy could also push up long-term yields and sow the risks of unanchored inflation expectations and intensified future policy volatility.

Market Dilemma Amid an Information Vacuum

There may be no fundamental error in Walsh's communication strategy itself, but the problem lies in the fact that his description of this strategy has created additional confusion. Positioning the Federal Reserve as a "referee" rather than a "player" is a misleading representation of market mechanisms, leaving market participants facing greater uncertainty when interpreting policy signals.

Armstrong believes that unless Walsh and the market are sufficiently lucky, this problem will become increasingly prominent over time. Even without a financial crisis, the strategy of "silencing forward guidance" is difficult to maintain indefinitely. Against the backdrop of lingering inflation risks and a continuously steepening yield curve, the communication tension between the Federal Reserve and the market will be a core variable that investors need to monitor closely in the next phase.