How Warsh demonstrated the Fed’s independence from Trump

Well done, Kevin Warsh – long live the independence of the central bank. The Financial Times is getting carried away by its enthusiasm: ‘Donald Trump fails to bend the Federal Reserve to his will’, reads the front-page headline. For the first time in three years, official interest rates have been raised – albeit slightly, by just 0.25 per cent – bringing them to a high of 4 per cent. The decision was widely anticipated, though by no means a foregone conclusion. Financial markets are celebrating, while the president is left with a bitter taste; nevertheless, he reaffirms his confidence in Warsh, whom he appointed in May, and takes out his frustration on the opposition lurking within the central bank’s board. In reality, the board voted unanimously, and not all its members were appointed by the Democrats. The thing is, we need to get to know Mr Warsh, writes Robert Armstrong in the British daily. The Wall Street Journal echoes this sentiment: ‘Warsh is a hawk’, reads the headline of its editorial, which opens by pointedly asking Elizabeth Warren to apologise – the Fed Chair is not Trump’s puppet, as the Democratic senator had labelled him. King Don would like interest rates at one per cent because the US is the world’s leading creditor, yet according to analyses conducted by the Federal Reserve at local level – not just nationally – he himself has caused the current inflation. First the tariffs, then the war in the Persian Gulf: oil products are more expensive, but core inflation is also rising, and the central bank cannot turn a blind eye. The message sent by Warsh this time is very clear: he intends to prevent the situation from getting out of hand, to stop the additional costs from becoming entrenched and creating a hard core of inflation; therefore, further increases are to be expected. Analysts estimate a further quarter-point rise by the end of the year. Generally, when the official cost of borrowing rises, stock markets fall, but Wall Street has welcomed the Fed’s determination and independence of judgement, to the extent that government bond yields have also fallen. Inflation that becomes structural drives down prices and raises the cost of debt, thereby offsetting the arithmetic effect on the face value of government bonds. This opens the door to the second part of the dilemma facing U.S. monetary policy, bringing the Treasury’s strategy and Scott Bessent’s moves to the fore.

On 22 August, Trump himself announced that Bessent had decided to intervene in the bond market by buying back short-term securities to replace them with longer-term ones, with the aim of preventing yields from exceeding 5 per cent. It is a sort of internal debt restructuring which, according to many interpretations, contradicts the Fed’s decision to raise interest rates. Bessent and Warsh, therefore, are pursuing two divergent paths. According to a different interpretation – a more benevolent one, or more ‘Trumpian’ if you will – these parallel paths will eventually converge. Whilst the Fed takes action to curb inflation, the Treasury buys and sells its own securities in such a way that yields do not exceed the set target. In this way, the effects tend to cancel each other out and the bond market stabilises. This is a crucial decision because this is precisely the black hole in the US economy.

The United States is not only the largest creditor, but also the largest debtor. This applies to both the private sector and the public sector. At over 40,000 billion dollars, gross federal debt now exceeds 125 per cent of GDP – a record in peacetime. Is it still sustainable? It is, even though the burden of the debt is increasing, now accounting for 15 per cent of federal expenditure – over $900 billion, roughly the same as the defence budget. This has a psychological impact, and not just on Americans themselves. Added to this is a new headache: the Treasury is convinced that the massive debt of the Big Tech firms could crowd out sovereign debt; in other words, it is absorbing money that could otherwise be used to support government bonds. Investors find themselves having to make difficult choices: artificial intelligence has a growing appetite for capital, and companies are willing to pay more in the hope that the desired profits will materialise. Taking a risk could be dangerous, but the Treasury’s guarantee alone is not enough to satisfy savers. So far, the buyback has not had any significant effect, but it is a medium-term operation. Will there be enough time? Warsh and Bessent seem like two skaters gliding across very thin ice, whilst beneath them the cauldron of debt is bubbling away.