The July Federal Open Market Committee (FOMC) may mark a significant shift in the way monetary policy should be interpreted. The U.S. Federal Reserve (Fed) no longer appears to operate through a single, clearly articulated reaction function. Instead, policy increasingly resembles a framework in which multiple reaction functions coexist across the FOMC, perhaps reflecting what Fed Chair Kevin Warsh has described as a "good family fight."

This matters because the traditional consensus-building model appears to be fading. Throughout the post-GFC (Great Financial Crisis) period, the Fed generally sought to deliver a unified policy signal, while allowing individual policymakers to express differing views at the margin. The emerging approach looks different. Rather than one dominant message, markets are confronted with a range of views and a greater degree of uncertainty about which perspective will ultimately prevail.

At the same time, the purpose of Fed communication appears to be evolving. The objective is no longer primarily to anchor short-term market expectations through detailed forward guidance. Instead, policymakers seem to be focusing on shaping a broader medium-term policy orientation. Monetary policy is becoming less dependent on any single inflation measure, labor-market indicator, or financial-market variable and more reliant on a wider assessment of underlying economic conditions.

That assessment likely encompasses alternative measures of inflation and labor-market dynamics, inflation expectations, market pricing, financial conditions, real interest rates, balance-sheet effects, and, importantly, questions of credibility and communication. The task forces introduced by Chair Warsh point in this direction.^[1]The consequence is a more flexible but also more complex framework, making policy shifts harder to anticipate. For markets that have grown accustomed to an exceptionally transparent and guidance-heavy Fed since the Great Financial Crisis, this represents a meaningful regime change.

The intellectual logic behind the new framework

The move away from a single, explicit reaction function is not merely a communication choice. It reflects a broader critique of how monetary policy has been conducted and interpreted over the last decade. Two ideas help explain the intellectual logic behind this shift: a version of the Lucas critique and a version of Goodhart’s Law. Fed Chair Warsh mentioned both explicitly at the July meeting.^[2]

• • The Lucas Critique warns that historical relationships can change when policies change because households, firms, and markets adapt their behavior. This is especially relevant when central bank communication becomes a dominant force in market pricing. If market participants adapt primarily to the expected policy reaction, the historical link between data, policy, and outcomes may become unstable.
  • Goodhart’s Law points in the same direction. Once a measure becomes a policy target, behavior adjusts around that measure, which can weaken its usefulness as a guide. Applied to inflation, this argues against relying too heavily on any single inflation measure. It supports a broader understanding of inflation dynamics and the need to distinguish underlying price changes from temporary fluctuations.

Taken together, these ideas support a more structural policy approach. The Fed would focus less on managing every data surprise through forward guidance and more on assessing whether broader inflation dynamics, market expectations, and financial conditions remain consistent with price stability. In such a framework, the Fed does not simply react mechanically to the next inflation print, payroll number, or market move. It evaluates whether the overall configuration of data, expectations, and financial conditions is compatible with its medium-term objective.

The immediate question is whether this new framework enhances policy flexibility or weakens confidence in the Fed’s commitment to price stability. That is why credibility is now the central variable.

Market reaction: a credibility test

The market reaction after the July FOMC was not simply about higher yields. It was about the composition of the move. The yield on 10-year US Treasuries rose by around 10 basis points. More importantly, the increase was driven primarily by higher breakeven inflation expectations rather than higher real yields. The curve steepened by about 10 basis points, while 30-year Treasury yields reached approximately 5.23%, reportedly the highest level since 2007. Credit default swaps (CDS) spreads remained broadly unchanged, suggesting that the initial reaction was not primarily driven by credit risk. The EUR/USD exchange rate rose by around 1 cent.

The most important signal was therefore not that yields rose, but why they rose. A move driven by inflation expectations rather than real rates points to a credibility issue. Markets appeared to question whether the Fed’s new framework would remain sufficiently restrictive to contain inflation.

Markets as an instrument of monetary policy

A central element of the emerging framework is likely a larger role for markets. Market pricing is not merely an output of Federal Reserve communication. It becomes an input into the policy process.

If markets are broadly efficient and unbiased, they can process incoming data quickly and adjust financial conditions before the Fed needs to act. In this sense, markets perform part of the Fed’s short-term work. Changes in inflation expectations, real yields, the yield curve, risk premia, and broader financial conditions can tighten or loosen policy conditions in real time.

The Fed’s role then shifts toward medium-term judgment. It assesses whether market-generated financial conditions are consistent with price stability, and whether market signals are informative or destabilizing. It steps in when market pricing, inflation expectations, or economic outcomes deviate too far from the desired path.

This is the likely logic behind reduced forward guidance. With less guidance, markets can rediscover prices rather than simply follow the central bank’s signposts. The benefit is potentially more informative market pricing and less dependence on Fed communication. The cost is higher volatility and less certainty about the Fed’s next move.

The trade-off is therefore clear. A less guided framework may improve price discovery, but it also raises the risk that markets misread the Fed’s intentions or challenge its credibility.

Policy implications: more volatility and larger steps

The most important implication is that policy expectations may become less stable. If the Fed provides less forward guidance and relies more on market price discovery, then market moves around data releases, speeches, inflation expectations, and financial conditions are likely to become more pronounced.

A less guided framework also changes the likely rhythm of policy adjustment. The traditional 25-basis-point step may become less central if the Fed waits for larger deviations before acting. This could produce periods of apparent patience, followed by larger adjustments once market signals, inflation expectations, or credibility risks justify a stronger response.

For investors, this means that the uncertainty around the reaction function becomes part of the risk premium. Markets must consider not only the economic data, but also how the Fed interprets those data. The policy path becomes less linear, less predictable, and more dependent on whether market-generated financial conditions are sufficient to preserve price stability.

At the same time, the market response itself may reduce the need for immediate policy action. Rising inflation expectations, higher term premia, and a steeper yield curve tighten financial conditions without any change in the policy rate. To the extent that these developments restrain demand and reinforce the transmission mechanism, markets are partially doing the Fed’s work for it.

The new framework may also make communication from voting FOMC members more important than lengthy press conferences. If the Committee is increasingly characterized by multiple reaction functions rather than a single consensus signal, markets will likely pay greater attention to the evolving views of individual policymakers. In such an environment, speeches and public remarks may offer more information about the future policy path than carefully crafted post-meeting communication.

This also changes the meaning of market volatility. Under the old framework, volatility often reflected uncertainty about the next Fed signal. Under the new framework, volatility may be part of the signal itself. The Fed may allow markets to move further before deciding whether those moves are consistent with its medium-term inflation objective.

Bottom line

The July FOMC points to a Federal Reserve framework that is less centralized, less dependent on traditional forward guidance, and more willing to allow markets to participate in the policy process. This shift could enhance the informational value of market prices and allow financial conditions to adjust more rapidly to new information.

The challenge is that such a framework places credibility at the center of monetary policy. The key question is how investors will interpret the reduced guidance. Will they view it as an expression of confidence in market-based price discovery, or as a sign of uncertainty regarding the Fed's response to inflation? The latter could lead to strong reactions that would materially tighten financial conditions, even without a change in the policy rate. Furthermore, the transition from guidance to discovery takes time, during which period central bankers may tolerate higher market volatility. For now, it seems that markets have interpreted the reaction function itself as a risk factor. While we do not yet see bond vigilantes at the gates, a combination of less confidence in the Fed and an unsustainable fiscal situation could build up strong forces. It remains to be seen whether this is the price signal that Fed Chair Kevin Warsh was looking for or whether markets will ultimately impose their will on the Fed.

Our assessment: risk to our Fed forecast uncomfortably high.

We continue to believe that maintaining the current policy rate will require progressively lower inflation readings over time. Several factors could contribute to this, including tariff-related disinflation, fluctuating oil prices, statistical base effects, and economic growth approaching its potential rather than significantly exceeding it. While large-scale AI investment supports current demand and may lead to future productivity gains, its short-term impact on inflation remains highly uncertain. Therefore, forecasting inflation remains extremely difficult because it depends on several key drivers that are subject to unpredictable external developments. For example, energy prices, geopolitical developments, trade policy, and broader supply-side shocks can significantly impact the inflation outlook.

Additionally, switching to a new framework or reaction function is risky. Weaning markets off long-used medication will have side effects. Based on what we have learned so far, it seems that Fed Chair Kevin Warsh chose a radical treatment by abandoning forward guidance entirely. Currently, the market’s fallback reaction appears to be the belief that the new approach might not lead to price stability.

The situation is further complicated by the fact that many aspects of the bigger picture are still unclear. For example, we don't know much about the role of labor markets in the target equation. While price stability may support employment in the long term, will the Fed respond to short-term fluctuations as it once did with insurance cuts? How will liquidity considerations and the role of the balance sheet factor into decisions? Another risk is that the Fed Chair might not be able to follow through with his ambitious agenda and could be outvoted by other FOMC members who have lost patience with the process.

Overall, risks to policy rates remain significantly skewed to the upside, making our forecast that the Fed will keep rates on hold uncomfortable, not so much because of the incoming and expected economic data, but more because of the political environment.

Overview: key economic indicators

* PCE Price Index

** Forecast

_{Source: Haver Analytics (Actuals), DWS Investment GmbH (Forecasts) as of July 31, 2026}

_{Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or analyses, which might prove inaccurate or incorrect.}