Kevin Warsh's bond market bind

Kevin Warsh hasn't even been sworn in as leader of the Federal Reserve yet, and his first great test has already arrived. The big picture: Global bond markets are sending borrowing costs markedly higher in this era of energy supply disruptions, AI-fueled demand for capital and massive fiscal deficits. The yield on 30-year U.S. Treasury bonds has surged to 5.11%, its highest level since 2007. The rate was 4.63% at the end of February. It sets up an environment where the Fed may well need to prevent inflation expectations — as reflected in bond traders' bets — from coming unmoored. It's a paradox of monetary policy: Sometimes, the only solution for higher long-term interest rates is higher short-term interest rates. Zoom out: Warsh has spent years criticizing the Fed for letting inflation run too hot for too long. Now, he's inheriting a bond market that's pricing in exactly that scenario. Warsh has argued that AI will ultimately be disinflationary — that productivity gains will lower the cost of producing goods and services and give the Fed room to cut rates. But now the AI capex boom is running so hot that it's offsetting the traditional growth-dampening effect of the oil shock, keeping demand resilient. Warsh's thesis may yet prove out. But the evidence for the disinflationary case hasn't shown up in the data yet, while the near-term inflationary scenario is plain to see in both the data and in every trip to the gas station or grocery store. Zoom in: U.S. demand has proven robust, and the Iran war has driven up energy prices, creating an inflationary surge. Government borrowing remains high, around 6% of U.S. GDP. As such, global investors are demanding higher compensation to park their money in Treasuries. But if the Fed were to cut its short-term interest rate target in the face of that shift, it could unmoor inflation expectations further, resulting in even higher long-term rates. Conversely, a pivot toward a rate hike or two this...

Original source: Axios