Is the bond market Federal Reserve Chairman Kevin Warsh’s preferred inflation-fighting tool via higher Treasury yields? Although he hasn’t explicitly said he wants long rates to rise to do the heavy lifting for the central bank in taming price pressures, he’s hinted at the possibility in recent comments. If that’s the strategy, the central bank may be comfortable with rising yields as a mechanism for cooling inflation while reducing pressure on policymakers to raise short-term rates and avoid, or at least minimize, the wrath of President Trump, who has demanded that the Fed cut rates.
Fed funds futures are pricing in a 67% probability that the Fed will raise its target rate at next week’s policy meeting, although that forecast is still close enough to a coin flip to keep Wall Street guessing.
The policy-sensitive US 2-year Treasury yield, by contrast, is reflecting higher confidence that a rate hike is near. The 2-year yield surged yesterday, rising to 4.59%, which marks the widest premium over the Effective Fed Funds Rate in nearly four years.
Although Warsh has been careful not to expressly call for higher yields in the bond market, several of his comments suggest he’s comfortable with tighter financial conditions and thinks inflation remains too high and that borrowing costs should therefore remain elevated.
One example: “I would be hard-pressed to describe broad financial conditions as restrictive,” he said last month at the Jackson Hole conference. “Real consumer spending has been healthy despite the shocks…” and “On the employment side of the Fed’s dual mandate, our country is doing well. Labor markets are quite stable.”
These and related comments imply that Warsh sees long-term rates as not yet sufficiently tight to restrain inflation, although perhaps less so in the wake of the rise in yields since he spoke last month.
He also said at Jackson Hole: “We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.” Some analysts have interpreted this statement as a sign that Warsh sees higher interest rates as necessary if inflation remains elevated.
Warsh was somewhat clearer on policy when he observed in late August: “Inflation is running above our 2% target. So the Fed’s predominant focus right now should be on prices.”
Perhaps the closest he came at Jackson Hole to seemingly endorse the bond market’s ability to implement tighter policy when appropriate was this observation: “To get policy right, we also need to get the relationship right between financial markets and the central bank. The Fed needs clear market signals, as unfiltered as possible.”
The runup in Treasury yields this month certainly looks like an unfiltered signal, and one that’s increasingly leaning into a hawkish pivot. The 10-year yield soared on Thursday, spiking to 4.97%, which is close to a three-year high.
In July, he was unequivocal that the Fed’s 2% inflation target remains the goal: “Let me reiterate: There is no soft inflation target … There’s only a target, and it’s 2%.” With inflation running above that mark, in some cases substantially so, depending on the metric, it’s easy to infer that some form of policy tightening is his preference, which in turn plays into the idea that’s fine with higher Treasury yields.
Even if Warsh’s preference for letting the market do the work of lowering inflation is accurate, there’s a potential glitch: the Treasury Department appears to be working at cross purposes. Treasury Secretary Scott Bessent’s recent efforts to expand government bond buybacks in an effort to push long-term borrowing costs lower could potentially undermine the Fed’s inflation fight.
Treasury’s efforts have, so far, failed, but a potentially conflicting dynamic may be brewing. If Treasury continues to ramp up its purchases, the program could eventually offset Warsh’s goal of market-driven tightening that would otherwise help restrain inflation.
Clarity from the Fed and Treasury, ideally through a unified message regarding their shared goals, would be helpful for the market. At the moment, however, their actions appear to be pulling in different directions, creating unnecessary uncertainty about the outlook for inflation and interest rates.
Next week’s Fed meeting and press conference offers Warsh an opportunity to explain the broader game plan: whether higher long-term yields are a desired feature of the inflation fight and how that view squares with Treasury policies aimed at pulling those same yields lower.
Is Recession Risk Rising? Monitor the outlook with a subscription to:
The US Business Cycle Risk Report