US Economy on Brink of Crisis: Will Fed's New Chair Hike Rates to Contain Inflation?

The US economy is facing a difficult hour, and it's time for the Federal Reserve to take action. The bond market is coming unstuck, inflation is rising, and President Trump's attacks on the Fed's independence are causing uncertainty. Next week's Federal Open Market Committee meeting will be crucial in determining whether Kevin Warsh, the new Fed chair, is up to the task.

The 30-year Treasury bond yield has reached a 20-year high of 5.25%, and the 10-year Treasury bond yield is approaching 5%. This is significant because the 10-year rate sets the benchmark for mortgage rates, auto loan rates, and other key borrowing rates. The Fed's fund rate, on the other hand, is no longer the primary concern.

The US economy relies heavily on foreign investors to finance its $2 trillion budget deficit, with foreigners owning around $8.5 trillion in outstanding US Treasury bonds - about 30% of all outstanding bonds. However, foreign investors are losing confidence in the US as a reliable economic partner due to concerns over debt and inflation.

The recent freezing of Iranian and Russian dollar deposits has fueled fears that bond holdings could be frozen, while President Trump's tariffs have added to uncertainty. Moreover, the Fed faces pressure from Trump to cut interest rates despite low unemployment and high inflation - around 3.5%. A key point that seems to be beyond Trump's grasp is that a soft-on-inflation Fed risks inviting a bond market crisis.

To contain inflation, the Fed needs to hike interest rates, proving its inflation-fighting credentials on the eve of the midterm elections and in the face of pressure from President Trump. By leaving interest rates where they are, Warsh could damage his credibility in the markets. It remains to be seen whether he has the courage to take the necessary steps.