Warsh Caught Between Trump and Bond Market Betting on Rate Hikes

(Bloomberg) -- Just three weeks into the job, Federal Reserve Chairman Kevin Warsh is already facing an unusually high-stakes test.

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Inflation is roaring back at the fastest pace in three years. There’s growing dissent among the central bank’s policymakers. And investors have been dumping US Treasury bonds and piling into bets the Fed will need to start raising rates by December, defying President Donald Trump’s call to lower them instead.

There’s little hanging on the outcome of the Fed’s policy meeting itself this week, since the bank is widely expected to hold its benchmark rate steady in a range of 3.5% to 3.75% while waiting to see how the Iran war’s energy-price shock ripples through the economy.

But Warsh’s maiden press conference — and the Fed’s post-meeting statement and forecasts — will be scoured for clues on what’s next.

If there’s a convincing message that the Fed is willing to shift back into inflation-fighting mode, Wall Street will likely be reassured about Warsh’s commitment to maintaining the bank’s political independence. Fall short, and it will rattle markets already worried he could jeopardize the Fed’s credibility by giving in to the White House.

“It’s just a very difficult position for him all the way around,” said James Clouse, an economist at the Andersen Institute and former deputy director of the Fed’s division of monetary affairs.

It’s never easy for a new Fed chief and some, like Alan Greenspan or Ben Bernanke, faced significant challenges not all that long after assuming the role.

Yet in Warsh’s case, the immediate conflict between the White House’s priorities and the direction of the economy is particularly fraught. The tension on Wall Street has been increased by questions about Warsh’s views and by a broader outlook complicated by war and an artificial-intelligence investment boom that’s pouring fuel on what’s been a surprisingly resilient economy.

Warsh was a staunch hawk during his term as Fed governor between 2006 and 2011, when the housing-market collapse drove the US into a deep recession.

But in the years since he morphed into a fierce critic of the central bank and last year faulted it for continuing to forecast elevated inflation, saying AI will unleash a “significant disinflationary force” by increasing productivity. Warsh’s silence since being sworn in last month — not atypical of a new chair trying to get his bearings — further complicates the picture.

“He’s not spoken to monetary policy in a really long time at this point,” said Ed Al-Hussainy, portfolio manager at Columbia Threadneedle in New York. “So we’re all reading the chicken entrails on what’s going on inside Warsh’s mind on monetary policy.”

Moreover, developments in the economy have shifted rapidly since Trump’s Iran war increased oil prices. As businesses see costs climb, they’re passing that along to consumers in the form of higher prices, adding to inflation that had already been stuck over the Fed’s 2% target for the past five years. In May, the consumer price index — one widely followed inflation gauge — climbed 4.2% from a year earlier, the most since April 2023.

That has sharply reset expectations on Wall Street. Traders have ditched once widespread bets that the Fed would resume cutting rates this year to wager on the opposite. Yields on two-year Treasuries have jumped to over 4%, above the Fed’s policy rate, while 30-year yields last month hit the highest since 2007. Both were seen as clear messages from Wall Street that rates need to head higher.

That’s not lost on Fed officials. At the latest meeting in April, many policymakers warned they’d likely need to start raising rates if inflation remained elevated and wanted to drop the bias toward lowering them, according to the minutes from that meeting. Three dissented because they objected to the wording of the Fed’s statement.

At the same time, Warsh is taking over in the wake of an unprecedented attack on the central bank by the Trump administration, including an effort to oust Governor Lisa Cook and a criminal investigation that Jerome Powell, Warsh’s predecessor, said was in retaliation for not bending monetary policy to the president’s will.

When Trump elevated Warsh to the board he said he respected his independence. But Trump repeatedly lashed out at Powell and this month said Warsh would be wrong to raise rates, asserting that the Fed should lower them instead.

“I’m hoping that the Kevin Warsh we see is the sort of card-carrying anti-inflation Kevin Warsh that was so present for many years, because inflation is too high,” said Ellen Meade, an economics professor at Duke University who advised Fed officials during a decades-long career at the board. “He needs to do something that demonstrates he understands the message from the incoming data.”

Some see concerns that Warsh could squander the Fed’s credibility to placate the president as overblown.

“There’s really no reason to expect him to just say ‘we’re lowering interest rates because the president wants lower interest rates’,” said Norbert Michel of the Cato Institute’s Center for Monetary and Financial Alternatives. “Kevin knows that’s not how things work.”

Still, Warsh has promised to mount a significant shakeup at the central bank that includes closer cooperation with the Treasury Department. He has said the Fed needs to change how it assesses inflation and communicates with the public, and he’s advocated reducing the central bank’s massive bond holdings — a step that has the potential to push up long-term rates by forcing markets to absorb more bonds.

Yet the more immediate focus will be on the signals that Warsh chooses to send about where he intends to steer the central bank over the next several months.

“Your first meeting will forever be your first meeting,” said Jason Granet, the chief investment officer at BNY in New York. “The statement, the minutes and the press conference — this meeting is going to have a lot to chew on.”

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