Raise interest rates? Warsh tries to buy time, the Fed is divided

The new chairman of the Federal Reserve – the US central bank – Kevin Warsh, has a problem. He would like to raise interest rates to combat inflation, but not before the mid-term elections, which are due to take place on 3 November. He wants to avoid snubbing President Trump, who has only just appointed him, with the explicit mandate to cut rates as soon as possible. Warsh’s concern is understandable. Although the Federal Reserve is independent, the effectiveness of monetary policy depends on the broader macroeconomic and political context. Starting a row with the White House is not the best way to begin one’s term at the helm of the central bank. Jerome Powell himself – Warsh’s predecessor – whilst publicly rejecting pressure from the President, nevertheless cut interest rates three times by the end of 2025 and refrained from raising them in 2026, despite inflation having risen from 2.4 per cent in January to 4.2 per cent in May.

In his first public appearance, in mid-June, Warsh announced that interest rates would remain unchanged but at the same time reassured the markets that the central bank’s top priority was to bring inflation back to 2 per cent. Observers had taken the message on board, anticipating that interest rates would rise sooner or later. Warsh’s communication strategy – aimed at buying time and ensuring that the markets ‘did the work for the central bank’ by pushing up long-term interest rates – had worked. Perhaps Warsh expected, partly on the basis of statements from the Administration, that the conflict would end quickly following the ceasefire agreement reached in mid-June, and that commodity prices would stabilise.

Last Wednesday, the US Federal Reserve once again opted to keep interest rates unchanged. However, the decision was not unanimous, as three of the twelve members of the Federal Open Market Committee voted in favour of a rate rise. This is a sign that, sooner or later, monetary policy will be tightened. Nevertheless, during the press conference, Warsh declined to give the markets any precise guidance on the central bank’s future stance, keeping all options open for the coming months. This has intensified concerns that the Fed is underestimating inflationary risks, as it did four years ago. And that it is not sufficiently independent to decide on a rate rise in the run-up to an election.

Long-term interest rates have thus continued to rise. Over the past month, yields on 10-year US Treasury bonds have risen by 30 basis points, approaching the 4.9 per cent mark – the 10-year high reached during the previous period of inflation in 2022–23. Yields on 30-year bonds have already reached a 20-year high of 5.2 per cent.

The negative effects are also beginning to be felt on the stock markets, which have been under pressure for several days. Experience shows that the longer a rate rise is delayed, the more severe that increase will have to be in order to bring inflation back within the stated target. The negative repercussions on the real economy and on companies’ balance sheets will be even more severe.

Warsh’s problem is that there are three months to go until the election, which is a long time for the financial markets. The Fed’s next Governing Council meetings will be on 16 September and 28 October. The second meeting falls in the week before the election. It seems unlikely that a rate rise will be decided on that date. Unless the outlook for the conflict in the Middle East changes drastically – a scenario that seems less likely with each passing day – inflationary pressures will not ease. Against this backdrop, the likelihood of a rate rise at the end of the summer and of an institutional clash with the White House is growing by the day.

The global repercussions are already being felt. Long-term European interest rates have risen in tandem with those in the US. Yields on 10-year German government bonds have exceeded 3 per cent, their highest level since 2011. Spreads on Italian and French government bonds have started to widen again.

Uncertainty over US monetary policy risks spilling over into other major economies. It seems increasingly likely that the European Central Bank will raise its key interest rates again, to 2.50 per cent, at its September meeting, to reassure the markets of its determination to combat inflation and to avoid being dragged into the shadow in which the Fed currently finds itself. Unless, that is, the Fed manages to emerge from it first.