Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Bond Market Puts Kevin Warsh on a Short Leash
Transcript
- Lucas: Kevin Warsh gets sworn in tomorrow as the 17th chair of the Federal Reserve. And he walks into a job where the bond market has already drawn its lines in the sand. Luna: We saw that in the headlines last week—Yardeni saying the Fed will have to hike in July just to keep the bond vigilantes at bay. But let's start with the numbers. What are yields actually doing right now? Lucas: The ten-year Treasury is at 4.59 percent as of this morning. That's down about two basis points over the past week, but it's still up sharply from where we were a few months ago. The five-year sits at 4.26 percent. The two-year, which is more sensitive to Fed policy, is at 3.58 percent. Luna: So the curve is steep, not inverted. That's telling us the market expects the Fed to keep rates higher for longer, but it's not pricing in a recession—yet. Lucas: Exactly. And that steepness is the bond vigilantes' signature. They're demanding a term premium for holding long-duration risk because they don't trust that inflation is truly contained. The 10-year breakeven inflation rate—the market's implied inflation expectation—is at 2.39 percent, down a touch from 2.44 percent a week ago. So it's not accelerating, but it's stuck above the Fed's 2 percent target. Luna: Meanwhile, core CPI for April came in at 335.4, up from 334.17 in March. That's a year-over-year increase of about 3.4 percent if I'm doing the math right. Still too hot for comfort. Lucas: You're right. And the core PCE, which the Fed prefers, stood at 129.3 in March. That's up from 128.9 in February. So the trend is not moving decisively downward. Warsh's challenge is that he inherits a Fed funds rate at 3.64 percent, effectively flat for months, while the economy is still generating price pressures. Luna: So does he have to deliver a hike at the July FOMC meeting just to prove he's serious? Or can he talk a hawkish game and let the data do the work? Lucas: That's the central question. Ed Yardeni, who coined the term 'bond vigilantes' decades ago, thinks the answer is clear. He told CNBC on Monday that the Fed will have to raise rates in July to appease the vigilantes. And remember, Yardeni has been more right than wrong on this stuff over the years. Luna: But Warsh has a reputation as a hawk. He was a Fed governor during the financial crisis, he's been critical of quantitative easing, he's close to the conservative wing of economics. You'd think the market already prices that in. Lucas: You'd think. But the market is watching actions, not vibes. The effective fed funds rate has been stuck at 3.64 percent since the last meeting. The interest on reserve balances is at 3.65 percent. No movement. If Warsh doesn't signal a hike soon, the vigilantes may sell off long-end bonds, driving yields even higher, and that would tighten financial conditions more aggressively than a quarter-point hike would. Luna: It's almost like the bond market is testing him before he even takes the oath. The ten-year yield spiked to over 4.7 percent earlier this month before settling back. That was a warning shot. Lucas: A clear one. And there's another dynamic here: the global backdrop. We've got the uk gulf trade deal being hailed as monumental, but more importantly for energy markets, there's the stalled Russian gas pipeline to China that Putin and Xi are trying to revive, all while geopolitical tensions in Iran rattle oil supplies. That keeps upward pressure on inflation expectations globally. Luna: So Warsh has to navigate domestic inflation that's sticky, a steep yield curve, and external energy shocks. Not an easy first month. Lucas: Let's talk about what his options actually are. He could come out of the gate with a hawkish statement at the June meeting, laying the groundwork for a July hike. Or he could hold steady and let the data deteriorate—or improve—on its own. Luna: But if he holds steady and inflation doesn't budge, he loses credibility. And once a Fed chair loses the bond market's trust, getting it back is painful. Just ask Arthur Burns or even Paul Volcker in his early days. Lucas: Volcker had to push rates to 20 percent to re-establish credibility. I don't think anyone wants a repeat of that. But Warsh has a different tool: communication. He's a lawyer by training, he understands signaling. He could use the press conference after the June FOMC meeting to send a very clear message without moving rates. Luna: Forward guidance, essentially. But forward guidance only works if the market believes you'll follow through. And with a new chair, there's a trust deficit until proven otherwise. Lucas: Right. The prior chair, Jay Powell, spent years building that credibility. Warsh starts from scratch. And the bond market is not in a forgiving mood. Luna: Before we dig deeper, I want to take a quick moment. This show is ad-free, and that's a choice we've made from day one. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo — that's literally what funds these conversations. It keeps us independent and focused on the substance. Lucas: Yeah, and we're grateful for that. It means we don't have to chase clicks or sponsors. We can just talk about what matters. So if you find value in that, the link is buy me a coffee dot com slash fexingo. Luna: Alright, back to Warsh. One thing I find interesting is how the AI economy narrative is intersecting with Fed policy. There's been a lot of talk about AI rewriting the American Dream, and some blue-collar workers might actually benefit. Could that change the inflation outlook? Lucas: Potentially, but not in the short term. ai driven productivity gains take years to show up in the data. In the near term, the investment boom in AI infrastructure is actually adding to demand—data centers, chips, energy. That's inflationary, not disinflationary. Luna: So Warsh might have to tighten into an AI investment boom, which could slow that growth. It's a tricky balance. Lucas: Exactly. And the market is watching how he handles that balance. If he raises rates too aggressively, he risks a downturn. If he's too slow, inflation expectations become unanchored. The sweet spot is narrow. Luna: What about the reverse? Could the bond vigilantes be sated by a credible commitment to data dependence? Warsh could say, 'We'll hike if inflation doesn't come down, but we won't pre-commit.' Lucas: That might work for a while. But the vigilantes want to see the whites of the Fed's eyes. They want a hike. And if they don't get one, they'll force the Fed's hand by driving long-term yields higher, which effectively tightens policy anyway. It's a form of discipline. Luna: So Warsh is damned if he does, damned if he doesn't, at least in the short run. Lucas: I think that's right. But he has one advantage: he's new. He can blame the lag in data, or the uncertainty from geopolitical shocks, to buy a meeting or two. The real test will be the July FOMC meeting. If core CPI is still running above 3 percent by then, the pressure to hike will be immense. Luna: Let's look at the calendar. The next FOMC meeting is June 16-17. That's in about three and a half weeks. Then July 28-29. So Warsh has two meetings to establish his footing. Lucas: And two CPI releases before July. The May CPI comes out June 10, the June CPI on July 15. Those will be pivotal. If May CPI shows a deceleration, he might get some breathing room. If it accelerates, all bets are off. Luna: What about the dot plot? The Fed publishes its summary of economic projections quarterly, and June is one of those meetings. Warsh could use the dot plot to signal a higher rate path without actually hiking. Lucas: That's a powerful tool. The dots are a collective forecast, but as chair, Warsh has outsized influence. If the median dot shifts to show one or two hikes this year, the market will price that in immediately. It's a way to tighten policy without moving the funds rate. Luna: But the dots can backfire. If the market thinks the Fed is too hawkish and sells off equities, that creates financial conditions tightening anyway. It's a delicate signaling game. Lucas: It really is. And Warsh is walking into that game with the bond market already poised to react. I think the key takeaway for listeners is that the new Fed chair is on a short leash. The bond market is the real master now, and it's demanding discipline. Luna: So we watch the ten-year yield. If it breaks above 4.7 percent again, that's a signal that the vigilantes are not satisfied. If it drifts lower, Warsh might have some room to maneuver. Lucas: Exactly. And we'll be tracking it all the way. Thanks for listening, and we'll be back soon with more on what Warsh actually does in his first weeks.