AI Optimism vs. Inflation Reality — Policy Dilemmas Facing Warsh as He Takes Office at the Start of H2

Market aftershocks from H1 have yet to subside; attention in H2 shifts to a new monetary policy landscape

Entering June, market focus has gradually shifted from the geopolitical conflicts of H1 toward the transition and implementation phase of Federal Reserve (Fed) leadership changes. In H1, Middle East tensions escalated from late February, peaked in uncertainty during March, and have recently progressed toward ceasefire agreements and Memorandums of Understanding (MOUs). Although as of June 1, leaders on both sides had not yet formally signed the MOU, financial markets have increasingly priced in an eventual resolution characterized by 'de-escalation and a return to normalcy.'

This geopolitical episode disrupted shipping through the Strait of Hormuz and pushed oil prices higher, amplifying upside inflation risks and exacerbating bond market volatility. However, as the marginal impact of these geopolitical shocks wanes, the key variable for H2 will be the policy direction set by newly appointed Fed Chair Warsh—particularly his first formal policy statement following the June FOMC meeting. How global central banks navigate a dynamic balance among the new chair’s policy vision, lagged inflation effects, and economic resilience will be the focal point for H2.

Key Drivers of Bond Market Pricing and Scenarios for the Interest Rate Path in H2:

Chair Warsh’s policy leanings, combined with the current high-inflation environment, significantly increase uncertainty around the interest rate path. The trajectory of the Fed’s benchmark rate in H2 will drive bond market repricing. We believe the following key factors should be considered in assessing this outlook:

– Scenario for resuming rate hikes:Strong economic data—for example, core PCE inflation at or above 3.5%, unemployment remaining below 4.0%, or signs of de-anchoring in inflation expectations. Under this scenario, the Fed could retain the option to raise rates further to contain inflation.

– Scenario for initiating rate cuts:Three core conditions: (1) A substantive resolution to the Strait of Hormuz issue and a notable decline in oil prices; (2) Clear signs of weakening in U.S. macroeconomic data; (3) Significant deterioration or a sharp selloff in risk assets.

– Scenario for holding rates steady:Given that inflation has not yet stably returned to the target range and the labor market remains resilient, FOMC officials may opt for a cautious ‘wait-and-see’ stance.

Warsh’s policy challenge: Can his optimistic AI-driven vision convince the FOMC to pivot decisively?

Warsh is optimistic about the development of artificial intelligence (AI) from a monetary policy perspective. He expects the widespread adoption of AI technology to boost productivity over the next few years, thereby generating a 'disinflationary' effect. Consequently, he favors preemptive rate cuts to support productivity growth, viewing this approach as analogous to Alan Greenspan’s historic decisions in the 1990s in response to the tech and internet revolution.

However, actually implementing this 'AI-driven preemptive rate cut' scenario in the second half of the year faces significant challenges, with clear divisions evident within the FOMC. Key reasons include:

1) The U.S. economy remains resilient, and inflation has yet to stabilize within the target range;

2) Greenspan’s success in the 1990s stemmed primarily from 'holding rates steady' rather than actively cutting them, and productivity gains typically push up the neutral rate, which does not necessarily justify rate cuts;

3) Today’s macroeconomic environment differs significantly from that of the 1990s; deglobalization and heightened geopolitical risks have substantially increased the likelihood of supply chain disruptions, making inflationary pressures more persistent.

Investment Recommendations:

The true test of the Fed’s leadership lies in knowing when to signal dovishness to stabilize market confidence and when to maintain a hawkish stance to anchor inflation expectations. Every public statement by past Fed chairs has often served as a critical guide for market positioning. Currently, markets have largely priced in no rate cuts through the second half of 2026—and during periods of elevated oil prices, even factored in potential rate hikes. However, with Warsh’s formal appointment as Chair, market focus has gradually shifted from 'whether to cut rates' to whether he can effectively manage market expectations and internal coordination, thereby creating reasonable room for policy easing. The real key to policy success lies not in any single rate hike or cut, but in balancing the more hawkish voices within the FOMC while delivering constructive policy signals that provide markets with a degree of positive forward guidance. This will ultimately determine where the Fed strikes its policy balance between controlling inflation and supporting growth in the second half of the year.

Looking ahead to the second half of the year, given the economy’s current resilience, lingering inflation concerns, and the lack of consensus on the policy path, investors should prepare for a 'Higher for Longer' interest rate environment. In today’s macro backdrop, a defensive and prudent strategy remains paramount. We recommend waiting for clearer policy signals and confirmed data trends before adjusting portfolio risk exposure. A relatively conservative allocation approach includes:

Allocating to money market funds and short-duration bond strategies:

– Benefiting from relatively clear yield advantages:Yields are at relatively high levels historically, offering attractive carry returns;

– Effective asset defense:Relatively low volatility effectively buffers against rising interest rates and geopolitical risks;

– Maintain a shorter-duration investment strategy:Diversify the portfolio on an average basis and strictly control duration to keep it relatively low, allowing for flexible adjustments based on subsequent data developments.

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