“Cometh the hour, cometh the man” is an old English proverb meaning that when a situation demands it, the right person will appear to deal with it. If ever an hour demanded courage from the Federal Reserve’s chair, it must be now, at a time when the US bond market is coming unstuck, a widening Middle East war is adding fuel to inflation, and President Trump continues his assaults on the Fed’s independence.
At next week’s scheduled Federal Open Market Committee meeting, we will get a good idea as to whether Kevin Warsh, the Fed’s new chair, is the man for our difficult economic hour. By hiking interest rates and proving his inflation-fighting credentials on the eve of the midterm elections and in the face of strong pressure from President Trump to cut interest rates, Warsh could prove that he is indeed the man for our economy’s difficult hour. By leaving interest rates where they are, he could do serious damage to his credibility in the markets.
Anyone doubting that we are on the cusp of a government bond market crisis has not been paying attention to market developments and the troubling actions by several important foreign investors. The 30-year Treasury bond yield has now climbed to 5.25 percent, a 20-year high. Meanwhile, the all-important 10-year Treasury bond yield is now approaching the psychologically important 5 percent level. Contrary to what President Trump might think, it is the 10-year bond yield rather than the Fed’s fund rate that is key for the economy. That long-term interest rate is the rate off which mortgage rates, auto loan rates, and other key borrowing rates are set.
A key vulnerability of the US economy is that it relies heavily on foreigners to finance its annual $2 trillion budget deficit. Indeed, foreigners own around $8.5 trillion, or around 30 percent of all outstanding US Treasury bonds. This makes it troubling that foreigners now seem to be losing confidence in the United States as a reliable economic partner. Last week, the Dutch central bank joined the French central bank in starting to move its gold deposits out of New York. Meanwhile, the Norwegian sovereign wealth fund, the world’s largest such fund, announced that it planned to reduce its US Treasury bond holdings by $80 billion.
Part of the reason foreigners appear to be losing their appetite for US Treasury bonds is that they fear the risk of their bond holdings being frozen. Fueling those fears are the recent freezing of Iranian and Russian dollar deposits and Trump’s aggressive use of import tariffs as punishment even against US traditional allies. However, another important reason why foreigners are becoming wary of holding US Treasuries is that they fear the US might be tempted to try to inflate its way out of its public debt problem. Fueling those fears are the unsustainable path of the country’s public finances and Trump’s relentless pressure on the Fed to cut interest rates even at a time of low unemployment and relatively high inflation.
The need to hike interest rates to contain inflation would seem to be particularly important when the labor market is strong and when forces are at play that could prevent the Fed from achieving its 2 percent inflation target anytime soon. It is not simply that inflation has exceeded the Fed’s target for more than five years and that inflation is currently running at close to 3.5 percent. It is that the renewed oil price spike to around $100 a barrel and the prospect of a super El Niño that could contribute to a surge in food prices could cause inflation to increase further.
A key point that seems to be beyond Trump’s grasp is that a Fed that is perceived to be soft on inflation is one that risks inviting a bond market crisis. If investors come to think that the Fed will tolerate higher inflation, they will demand a higher interest rate on their bonds to compensate for the risk of higher future inflation. We must hope that Warsh understands this point and has the courage to raise the Fed’s interest rate to assure the market of his inflation-fighting credentials.