Yield Curve Twist Shows Markets Question Fed's Inflation Commitment

Mike Maharrey

If you have a choice between believing the audio or the video, believe the video.

In other words, trust what you see if it differs from what you hear.

Since Kevin Warsh stepped into his new role as chairman of the Federal Reserve, he has been speaking forcefully, insisting the central bank will not tolerate price inflation running hotter than the mythical 2 percent target. He reinforced that message after the July FOMC meeting, saying, “You’ve heard this before, but we will deliver price stability.”

But what has the Fed actually done?

Nothing.

Warsh & Company held interest rates steady in June and July. That marked the fifth straight meeting without a rate change, even though inflation remained anchored well above the 2 percent target. The central bank also continues to run quantitative easing (QE) operations, as shown by the expanding balance sheet. Since QE involves buying bonds with money created out of thin air, it is inherently inflationary.

The audio says this is a hawkish Fed. The video tells a different story.

Believe the video.

The Fed's Catch-22

I have been saying for months that the Fed will have a difficult time raising interest rates because of the Debt Black Hole dominating the economy. It is easy to say, “We'll fight inflation to our dying breath.” It is a different matter to engage in that fight when you know it could lead to the economy's dying breath.

The Fed remains in a Catch-22. It would undoubtedly like to hike rates and strangle price inflation once and for all. But it would also like to avoid crashing the economy.

And make no mistake, the economy is teetering on the edge. We have never dealt with the malinvestments and bubbles created by the unprecedented monetary policy of the pandemic era, or even the money creation during the Great Recession. The economy is addicted to that easy money. That means it needs to cut rates to keep the debt bubble inflated.

It cannot do both.

Historically, the Fed has chosen inflation over allowing the economy to sink, as seen during the 2008 financial crisis and the pandemic. There is no reason to think Warsh will be any different, despite his rhetoric.

The Markets Don't Believe Warsh Either

I have been skeptical of Warsh from the beginning. Now the markets do not seem to believe his tough talk either.

Movement in Treasury yields suggests investors do not expect the central bank to follow through on its hawkish rhetoric. In monetary economics, this is fundamentally a question of central bank credibility—the degree to which markets believe a policymaker will follow through on stated commitments. Once that credibility erodes, expectations of future inflation become self-reinforcing, as investors demand higher yields to compensate for inflation they no longer trust the Fed to contain.

After the Fed announced its decision to stand pat last week, yields on the long end of the curve spiked. The 10-year Treasury yield rose 5 basis points to 4.657 percent. The 30-year Treasury bond yield climbed 9 basis points to 5.193 percent.

That suggests markets believe the Fed is finished with rate hikes. As a CNBC report put it, “We think you're going to keep short-term policy rates in check, and it's going to create a ton of inflation later.”

Reuters explained it this way:

“In this case, the twist that materialized around July 31 carried a clear message. Short-term yields, which are more sensitive to imminent Fed policy, stayed relatively anchored. Meanwhile, long-term yields pushed higher, reflecting expectations about sustained economic growth and persistent inflation rather than fears of additional rate hikes.”

This pattern—long-term yields rising while short-term yields hold steady—is known in bond market terminology as a bear steepener, and it has historically signaled investor concern about future inflation rather than confidence in tighter monetary policy ahead.

Several mainstream analysts also argued that the Fed's inflation war amounts to little more than a war of words. Citigroup global chief economist and former Fed employee Nathan Sheets said the markets appear to be voting “no confidence” in the Fed's ability to control price inflation.

“He highlighted a problem and gave no strategy for solving it other than, 'I'm a hawk, trust me,' and the markets wanted more than that. I think part of it is if you lean too far into future hikes, then he's disappointing the White House. And it is a balancing act between Warsh the hawk, which he is, and trying to stay on sides relative to 1600 Pennsylvania Avenue.”

Meanwhile, Warsh has hinted that the central bank may try to move the goalposts when it comes to calculating price inflation. Historically, the target has been a Personal Consumption Expenditures Price Index (PCE) reading at 2 percent. The Fed favors the PCE because it understates inflation the most.

During his confirmation hearing, Warsh indicated that he preferred “trimmed averages” for price inflation.

As Reuters explained, in theory, this approach “trims off the fastest-rising prices and fastest-falling prices, leaving a more representative middle set of price changes that typically serves as a good indicator of where inflation is heading.” It is worth noting that the Federal Reserve Bank of Dallas already publishes a Trimmed Mean PCE measure using a similar methodology, which some economists regard as a more stable gauge of underlying inflation trends than headline PCE.

During his post-meeting press conference last week, Warsh again suggested the central bank could adopt a new standard. He initially insisted the PCE is “our number, we're sticking with it.” But he added, “Who knows, come after next January, what we might say about strategy. I suspect the task forces might have something to add.”

Warsh has formed several task forces to evaluate the mechanizations of the central bank. His statement appeared to suggest those task forces may move the goalposts.

Reuters summed it up by reporting that “the combination of Warsh's repeated assertions of the need to tame inflation with no action to move it toward the 2 percent target and a hint that the goalposts themselves may change” was behind the recent jump in yields on the long end of the curve.

What Does This Mean for Gold and Silver?

Gold and silver have traded sideways over the last few months because markets believed the Fed would keep rates higher for longer, and perhaps even hike, to confront persistent price inflation.

What happens if the market has lost faith in the Fed's inflation-fighting credentials?

This twist in the yield curve also has implications for the dollar, pointing to the possibility of a weaker dollar. Add to that the Treasury Department's apparent willingness to buy yen to strengthen the Japanese currency, and a persistently weakening dollar could emerge. The inverse relationship between the dollar and precious metals is well-documented, as a weaker dollar makes gold and silver cheaper for international buyers holding other currencies, typically boosting demand.

That is bullish for gold and silver.

While higher interest rates on the long end of the curve could be considered bearish, given that gold and silver are non-yielding assets, higher inflation is bullish because the metals have historically served as an inflation hedge.

It is also important to consider real interest rates, not just the nominal yields quoted on television.

The real interest rate is the stated rate adjusted for price inflation.

To calculate it, you take the quoted interest rate and subtract CPI.

The federal funds rate is currently set at 3.5 percent. When you factor in CPI of 3.5 percent, the real rate is 0 percent. (3.5 - 3.5 = 0.)

In a low-interest-rate environment, or when price inflation is especially high, real interest rates can go negative. For example, if CPI is 3.6 percent, the real interest rate would be -0.1 percent.

When real rates are taken into account, higher yields are not necessarily bearish for gold and silver. It may feel like you are earning a good yield, but inflation eats into those gains.

So even if yields on the long end of the curve continue to rise, and they likely will if we are in the early stages of a secular bear market in bonds, real yields may remain relatively steady and could even begin to fall as inflation continues to run hot.

And if the economy turns over and the markets collapse, the Fed will almost certainly rush to cut rates and ramp up QE.

Money Metals CEO Stefan Gleason has explained how interest rates and price inflation interact in the real world.

Summing it all up, Warsh will undoubtedly continue to talk tough on inflation.

But remember: watch the video.

It appears that is exactly what the markets are doing.

About the author

Mike Maharrey

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