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Investors are increasingly worried about government deficits and persistent inflation, driving up the price of money. The Federal Reserve can ease some of those nerves.
The conflict in the Middle East intensified last week, pushing up energy prices again and forcing heavily indebted countries to borrow more to increase defense spending and fund the war. That deepened a global rout in the bond market, sending yields to multi-year and multi-decade highs. Higher yields raise borrowing costs for consumers for everything from mortgages and credit cards to the US government’s $40 trillion debt.
Fed Chairman Kevin Warsh has been mostly silent on where he believes interest rates could be heading. However, in a major speech last month at an economic symposium in Jackson Hole, Wyoming, Warsh gave markets a hint, saying there was more “work to do” in fighting inflation — a signal that rate hikes could be around the corner.
Investors welcomed Warsh’s Jackson Hole speech, underscoring how keen they are to get more clarity on his economic views. Fiscal concerns and a flood of corporate borrowing to fund the AI build-out are the biggest drivers of the surge in yields. But greater transparency from Warsh could be an important source of stability for the bond market — and a much better alternative to the central bank deploying its massive $6.7 trillion balance sheet to control yields, as it did during the Great Recession and World War II.
“The Fed’s responsibility is confined to just controlling inflation and if Warsh can just explain policy better in the next few months, then that source of anxiety is likely to ease,” Derek Tang, a policy economist at Monetary Policy Analytics, told CNN. “But the Fed does have firepower with its unlimited balance sheet.”
US Treasury yields ticked slightly higher on Tuesday as traders monitored oil prices and geared up for inflation data set to be released later this week. After surging last week, yields were steadier this week. The 10-year yield traded at 4.79%, near its highest level since 2025 and on the cusp of its highest level since 2023.
Warsh has said repeatedly that the Fed is committed to its 2% annual inflation target. But that hasn’t been enough to reassure bond investors.
Shortly after Warsh held a news conference following the Fed’s July monetary policy meeting, long-term bond yields surged. That was likely a reflection of doubts about the Fed chairman’s commitment to taming inflation, an adjustment period to a quieter Fed, or simply expectations for future rate hikes.
But Warsh has not provided what’s known as a “reaction function,” which is the central bank’s explanation of “what it is watching, how it interprets the economy, how it weighs competing risks, and what developments would change its judgment,” according to the Brookings Institution.
While Warsh didn’t flesh out a reaction function in his Jackson Hole speech, his signal that rate hikes may be coming was a step in the right direction.
“Warsh needs to continue to refine how he communicates with markets,” said Jim Baird, chief investment officer at Plante Moran Financial Advisors. “Part of that is providing assurance that policymakers will take policy action in a reasonable time frame.”
Markets see a roughly 60% chance the Fed will raise rates at its meeting next week, underscoring the persistent uncertainty on Wall Street. That would mark the first rate increase in more than three years. Investors expect at least one more rate hike by year’s end, but the timing remains unclear.
But the Fed does have an unconventional tool to influence long-term yields: Its balance sheet. Yet it is highly unlikely the central bank will use it.
“The Fed has the ammo to be much more impactful on the level of interest rates by introducing quantitative easing,” said Mike Goosay, chief investment officer and global head of fixed income at Principal Asset Management. “But I don’t think that’s going to happen.”
In response to the Great Recession, the Fed massively expanded its balance sheet by buying up bonds and mortgage-backed securities to inject money into the financial system and stimulate the economy at a time when interest rates were already near zero. Warsh, who was a Fed governor during that period, said he supported the first round of quantitative easing, or QE, as an extraordinary emergency measure.
But officials later introduced two more rounds of QE, which succeeded in stabilizing markets and aiding an economic recovery. But it prompted Warsh to resign. At the time, Warsh described the Fed’s large-scale asset purchases as “reverse Robin Hood,” arguing that it benefited wealthy asset owners while hurting everyday households. Since becoming Fed chairman, Warsh has stressed that the central bank must go back to basics, making it highly unlikely that he would support QE this time around.
That wasn’t the only time the Fed has used its balance sheet to influence long-term borrowing costs.
“In World War II, the Fed thought it had a duty to support the war effort, so it used its balance sheet to hold down bond yields to make sure that the government could spend more,” Tang said. “But we’re not in a world war right now.”
The Fed did this by setting a fixed low price for Treasury bills and long-term bonds, then bought all the bonds that private buyers did not want — all while keeping short-term interest rates low.
But this policy came at a cost: The Fed effectively surrendered its independence, making it harder for policymakers to tame inflation. That arrangement ended with the 1951 Treasury-Fed Accord, which restored the central bank’s independence from the Treasury.
Warsh has said the Fed’s independence is essential — and that matters for the bond market. If investors believe that the Fed is willing to make unpopular monetary policy decisions to control inflation, they are more likely to have trust in its commitment to price stability.
Ultimately, convincing investors that it will act to keep inflation under control is the simplest tool the Fed has to calm the bond market.
