Fed's Kevin Warsh Seeks to Calm Bond Market with Clear Communication

Article by Xiao Yanyan, Jin10 Data

Investors' concerns about government deficits and persistent inflation are driving up funding costs, while the Federal Reserve still has room to ease tensions in the bond market.

Last week, the escalation of conflict in the Middle East once again pushed up energy prices, forcing fiscally strained nations to borrow more to expand defense spending and fund the war. As a result, global bonds faced further selling pressure, pushing yields to multi-year or even multi-decade highs, which in turn increased consumer borrowing costs through mortgages, credit cards, and other channels, while also intensifying the repayment burden on the U.S. government’s $40 trillion debt.

Former Federal Reserve Chair Kevin Warsh had previously remained relatively silent on the outlook for interest rates. However, at last month’s economic symposium in Jackson Hole, Wyoming, he sent a significant signal: more “work remains” to combat inflation, suggesting further rate hikes could lie ahead.

This statement was welcomed by investors and reflects the market's urgent demand for greater transparency in Walsh's economic views. Key factors driving the current rise in yields include fiscal concerns and large-scale bond issuances by corporations to finance artificial intelligence initiatives.

Derek Tang, policy economist at Monetary Policy Analytics, told CNN: “The Fed’s mandate is solely to control inflation; if Walsh can better explain the policy over the coming months, this source of anxiety may ease.”

However, Derek also pointed out that the Federal Reserve still possesses the firepower of an "infinite balance sheet."

On Tuesday, U.S. Treasury yields rose slightly as traders monitored oil prices while awaiting inflation data to be released later this week. After a significant rise last week, yields have stabilized this week.

The 10-year U.S. Treasury yield is currently trading at 4.80%, nearing its highest level since 2025 and approaching its highest level since 2023.

Wash has repeatedly reaffirmed the Fed's commitment to achieving its 2% annual inflation target, but this statement has still not fully allayed concerns among bond investors.

Shortly after the press conference following the Fed’s July monetary policy meeting, long-term bond yields rose noticeably. This could reflect market skepticism about Walsh’s commitment to controlling inflation, may be linked to the Fed entering a more muted adjustment phase, or could simply indicate investors beginning to price in the possibility of future rate hikes.

What the market currently lacks is further clarification from Walsh on the Fed’s “reaction function.” According to the Brookings Institution, this concept refers to what the central bank is monitoring, how it interprets the economy, how it weighs competing risks, and what changes would alter its assessment.

Although Wash did not elaborate on this framework in his Jackson Hole speech, the mere signal of a rate hike has been viewed as a step forward in communicating with the market.

Jim Baird, Chief Investment Officer at Plante Moran Financial Advisors, said: “Wash needs to continue refining how he communicates with the market.” He believes one important aspect is convincing the market that policymakers will act within a reasonable time frame.

Currently, the market believes there is a roughly 60% chance that the Federal Reserve will raise interest rates at its meeting next week. If a rate hike occurs, it would be the first increase in over three years; investors also expect at least one additional hike before the end of the year, though the timing remains uncertain.

The pressures facing the bond market are not limited to monetary policy. Fiscal deficits, inflation, and the financing boom driven by corporate investments in artificial intelligence could continue to push up long-term borrowing costs. In this context, clearer policy communication could serve as a direct means of stabilizing market expectations.

The Federal Reserve does have another tool that can influence long-term yields: its balance sheet. However, market participants generally believe that the Fed under Walsh is very unlikely to use this tool.

Mike Goosay, Chief Investment Officer and Global Head of Fixed Income at Principal Asset Management, said: “The Federal Reserve has sufficient ammunition to have a greater impact on interest rates through quantitative easing.” However, he believes this scenario will not occur.

During the Great Recession, the Federal Reserve significantly expanded its balance sheet by purchasing bonds and mortgage-backed securities to inject liquidity into the financial system and stimulate the economy while interest rates were near zero.

At the time, Walsh, then a member of the Federal Reserve Board, supported the first round of quantitative easing (QE), viewing it as an emergency measure taken during extraordinary circumstances. Subsequently, the Fed implemented two additional rounds of QE, successfully stabilizing markets and spurring economic recovery—but this also became one of the reasons for Walsh’s eventual resignation. At the time, he referred to the Fed’s large-scale asset purchases as a “reverse Robin Hood,” arguing that the policy benefited wealthy asset holders at the expense of ordinary households.

Since becoming Fed Chair, Wash has consistently emphasized that the central bank needs to return to fundamental principles, making it even less likely that he would support QE under current conditions.

The Federal Reserve has previously used its balance sheet to directly lower long-term borrowing costs.

Derek noted that during World War II, the Federal Reserve felt obligated to support the war effort, so it used its balance sheet to suppress bond yields and help the government increase spending. "But we are not currently in a world war," he said.

At the time, the Federal Reserve purchased all bonds that private investors were unwilling to buy by setting fixed low prices for short-term Treasury bills and long-term bonds, while maintaining low short-term interest rates.

This policy came at the cost of diminished independence and made it harder for policymakers to control inflation. Ultimately, this arrangement ended with the 1951 Treasury-Fed Accord, restoring the Federal Reserve’s independence from the Treasury.

Wash previously emphasized that the Federal Reserve's independence is crucial, and this same principle applies to the bond market.

When investors believe the Federal Reserve is willing to implement potentially unpopular monetary policies to control inflation, they are more likely to trust the central bank’s commitment to price stability.

For today’s bond market, the Fed’s more direct approach may still be to convince markets that, in the face of inflationary pressures, it will ultimately act—rather than reactivating its $6.7 trillion balance sheet to influence long-term yields.