Greenspan's "conundrum" re-emerges; will Waller use rate hikes to drive down long-term interest rates?

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The new Fed Chair, Warsh, is facing a historically resonant policy choice: raising interest rates might actually suppress long-term rates, thereby achieving the Trump administration’s much-desired goal of lowering mortgage rates.

As the Fed holds its policy meeting this week, the bond market has priced in a 38% probability of a federal funds rate hike—a sharp jump from under 10% before Warsh testified before the Senate Banking Committee. Bloomberg Economics’ Fed sentiment index shows the current policy team’s overall hawkishness is at its highest since the 2023 rate hiking cycle, with a clear hawkish tilt among the seven voting members.

Although a rate hike is not the baseline scenario this time, a logical chain is quietly circulating in the market: If Warsh raises rates to bolster anti-inflation credibility, it could compress the inflation premium embedded in long-term rates, thereby reducing mortgage rates, auto loan rates, and real borrowing costs—precisely what the White House truly desires.

Policy Lessons from the Greenspan "Conundrum"

This logic is not without precedent in history. The late Fed Chair Alan Greenspan encountered a similar situation in 2004: The Fed raised the federal funds rate from 1% to 4.75% by early 2006, but long-term bond yields fell rather than rose, with 30-year mortgage rates dropping from a high of 6.34% in mid-2004 to a low of 5.47% a year later. This phenomenon was later called the Greenspan "conundrum."

However, Bloomberg Opinion executive editor Robert Burgess pointed out that this is less a "conundrum" than a reflection of the market’s forward-looking pricing mechanism—every rate hike reinforces investors’ confidence in the central bank’s anti-inflation commitment, putting downward pressure on long-term rates.

Treasury Secretary Bessent is no stranger to this logic. Early last year, he made it clear that the focus of his and Trump’s administration is to lower long-term rates, not push the Fed to cut short-term target rates. Tom Porcelli, chief economist at Wells Fargo Securities, highlighted this in a client report last week:

"We frequently hear people who expect the Fed to hike soon say that by raising rates, Warsh can achieve the result he and Bessent truly desire—lower long-term rates. The logic is that rate hikes reinforce Warsh’s anti-inflation credibility and compress the inflation premium in the long-term rate market."

Warsh’s Hawkish Posture and Independence Statement

Since taking over the Fed from Powell in May, Warsh has continuously sent strong signals to the public. At the Senate Banking Committee hearing on July 15, when asked whether he keeps in touch with Trump, Warsh stated clearly:

"I have repeatedly told the President and the Treasury Secretary the same thing: they chose an independent person to do an independent job, and that is precisely my plan."

Bloomberg Economics commented on the hearing, saying Warsh "unapologetically displayed a hawkish stance," and judging that after inflation stayed above the Fed’s 2% target for 63 consecutive months, price stability is a much tougher task than full employment. Warsh further pointed out that the construction of AI infrastructure is exacerbating inflationary pressure, as demand-side shocks appear faster than supply-side responses.

Notably, as soon as Warsh finished speaking, the 10-year Treasury yield immediately fell, marking the largest single-day drop in three weeks—a micro version of the "Greenspan conundrum," where hawkish statements actually sent long-term rates down.

New Chair Rate-Hike Tradition and Current Constraints

Historical precedent is also worth examining. According to TS Lombard strategist Dario Perkins, Paul Volcker started hiking rates less than two months after becoming Fed Chair; Greenspan, Ben Bernanke, and Powell all took action within a month of taking office; Janet Yellen was the exception—she did not hike until 22 months into her tenure. Perkins wrote to clients:

"Rookies always start with a hawkish posture; it helps build anti-inflation credibility. Volcker captured this atmosphere in one sentence when he congratulated Greenspan on his first rate hike: 'Congratulations—you are now a true central banker.'"

However, real-world constraints cannot be ignored. The latest inflation data show price pressures have eased somewhat. Five working groups established by Warsh are conducting a comprehensive review of Fed operations, with results expected by year-end. Tightening monetary policy abruptly before those findings are released would be a delicate timing choice. Furthermore, Warsh only holds one vote on the FOMC; changing policy rates requires seven votes.

Nonetheless, with several members having hinted at the need for further tightening, the threshold may not be as difficult to clear as it appears. Even if rates aren’t raised this week, the mainstream market view is: Warsh is systematically strengthening his anti-inflation credibility, which itself may already be the most powerful precondition for lowering long-term rates.

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