Is Kevin Warsh's Bark Worse Than His Bite?

Federal Reserve Chairman Kevin Warsh came out swinging at Jackson Hole on Friday.

Inflation remains too high. The Federal Reserve needs to remain vigilant. And if inflation doesn't continue moving toward the Fed's 2% target, Warsh made it clear that policymakers may have more work to do.

His most important line may have been:

“We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.”

That certainly sounds hawkish.

But here's the bigger question investors should be asking:

How Tough Can Kevin Warsh Really Be?

The Federal Reserve doesn't operate in a vacuum.

America's national debt has now surpassed an astonishing $40 trillion. At the same time, long-term Treasury yields have been putting increasing pressure on the government's borrowing costs.

In fact, the Treasury recently announced that it would double the size of certain buybacks of 10- to 30-year Treasury securities after the 30-year yield reached its highest level in nearly two decades.

Think about the message that sends.

The Treasury is already taking steps designed to improve liquidity in the long end of the bond market while the federal government continues borrowing enormous amounts of money.

And there's much more borrowing coming.

Treasury currently estimates approximately $739 billion of net marketable borrowing in the July-through-September quarter alone, followed by another $628 billion in the fourth quarter.

Now imagine the Federal Reserve aggressively raising interest rates into that environment.

Higher rates don't just affect Wall Street.

They can eventually mean higher borrowing and refinancing costs for the federal government, higher mortgage rates, more expensive business loans and greater pressure throughout an economy that is already showing signs of slowing.

Then There's the Jobs Market

This is where Warsh's tough talk gets even more interesting.

Warsh described the labor market Friday as consistent with “full employment.”

But the latest numbers aren't nearly as reassuring.

The U.S. actually lost 23,000 payroll jobs in July, while May and June employment figures were revised downward by a combined 103,000 jobs.

Private payrolls increased by only about 30,000.

That isn't exactly an economy firing on all cylinders.

And economic growth has slowed as well.

Real GDP grew at an annualized rate of only 1.5% during the second quarter, down from 2.1% during the first quarter.

We're not in an official recession based on those numbers.

But the combination of slowing growth, weak job creation, enormous federal borrowing and stubborn inflation puts the Federal Reserve in an increasingly difficult position.

The Fed's Dilemma

If inflation remains elevated, Warsh may want higher rates.

But every additional rate increase risks putting more pressure on:

Consumers. Businesses. Housing. Employment. Financial markets. And ultimately the federal government's own borrowing costs.

That's why Friday's speech may ultimately prove to be a case where Kevin Warsh's bark is worse than his bite.

That doesn't mean the Fed can't raise rates.

It absolutely can.

In fact, markets took Warsh's speech seriously and increased expectations for another rate hike.

The question is how far can the Fed realistically go before the cure begins causing more damage than the disease?

That distinction matters enormously for investors.

And That Brings Us Back to Gold

Gold pulled back following Warsh's hawkish comments Friday.

That's understandable.

Gold doesn't pay interest, so expectations for higher interest rates can create short-term pressure on precious metals.

But investors shouldn't confuse a short-term market reaction with the disappearance of the longer-term forces that have helped drive gold higher.

The United States still has more than $40 trillion in national debt.

The government still needs to borrow hundreds of billions of additional dollars.

The labor market is showing signs of weakness.

Economic growth has slowed.

Inflation remains above the Federal Reserve's target.

And policymakers face an increasingly difficult balancing act between fighting inflation and avoiding unnecessary damage to the economy.

Gold is fundamentally different from Treasury debt, corporate bonds or other financial promises.

Gold isn't someone else's liability.

It doesn't depend on the U.S. government's ability to refinance its debt, and it doesn't require a corporation or financial institution to make good on a promise.

That's one reason physical precious metals have historically been considered a portfolio diversifier and potential hedge against inflation, currency uncertainty and financial instability.

A Pause—or an Opportunity?

Nobody can consistently predict short-term movements in gold.

Gold could move lower before moving higher again, and investors should make decisions based on their individual objectives, risk tolerance and overall financial situation.

But if you've been considering adding physical precious metals to your portfolio, the recent pause following Warsh's Jackson Hole speech may be worth paying attention to.

Because while Kevin Warsh can certainly talk tough about inflation, the Federal Reserve must ultimately operate within the economic reality surrounding it.

And today that reality includes:

• $40+ trillion in federal debt.
• Massive ongoing government borrowing.
• A weakening employment picture.
• Slower economic growth.
• And inflation that still hasn't gone away.

Warsh may have plenty of bark.

The question investors need to ask is just how much room he really has to bite.