What is "The Warsh Shadow Rate"?

The Federal Reserve's Chair Kevin Warsh has signaled a more hawkish stance on inflation, potentially leading to a September rate hike. However, softer incoming data could still postpone the decision, according to Citi Research. Citi has developed a "Warsh shadow rate" based on Warsh's key indicators highlighted in his Jackson Hole speech.

This gauge is close to historical highs and often predicts two-year Treasury yields, implying increased probability of future monetary tightening. Warsh's focus on inflation, money supply, labor market data, financial conditions, and equity market indicators suggests a more aggressive monetary policy. However, indicators he downplays, such as inflation expectations, wages, and nonfarm payrolls, have softened.

The bank argues that a 0.3% or higher core CPI increase would likely trigger a hike, while a 0.1% increase could postpone it. The implications of a 0.2% reading are less clear. This hawkish posture has pushed U.S. Treasury yields higher, particularly the 10-year yield, while rising oil prices add pressure on the long end of the yield curve.

Citi predicts that equities may initially weaken following a first Fed hike, while bonds tend to perform poorly for an extended period.