Warsh will speak for the first time in Jackson Hole; will the Federal Reserve and the Treasury reach a new version of the "fiscal-monetary agreement"?

Warsh will speak for the first time in Jackson Hole; will the Federal Reserve and the Treasury reach a new version of the "fiscal-monetary agreement"?

Federal Reserve Chairman Warsh will make his first public appearance at the Jackson Hole Economic Symposium this Friday, while the U.S. Treasury has quietly begun its debt management transformation, and an informal coordination framework between the two policy institutions is gradually taking shape. Markets are closely watching whether a modern "fiscal-monetary agreement" will be formally established at this event.

Warsh's remarks marked his first public statement since the controversy surrounding his July interest rate decision. Meanwhile, Treasury Secretary Bessant intervened directly in the market last week by increasing unplanned bond buybacks and explicitly stated that "yields have failed to reflect fundamentals," a clear departure from Warsh's previous stance that "rising yields are a good thing." This tension between the two institutions has significantly heightened market expectations of an urgent need for policy coordination.

The current situation puts pressure on both sides. The Federal Reserve faces the difficult choice of reducing its balance sheet, and any aggressive action could further push up long-term yields; the Treasury, burdened by an annual deficit of approximately $2 trillion, continues to shift debt issuance towards the short term, thus becoming heavily reliant on loose monetary policy. The market has already priced in a 78% probability of a rate hike this year, making this coordination both more difficult and necessary.

Walsh faces a credibility test, with long-term yields becoming the crux of the problem.

The theme of this year's Jackson Hole conference is "Financial Innovation: Implications for Payments and Policy," and the agenda itself does not directly point to a path for monetary policy. However, expectations for Warsh's speech have far exceeded the agenda framework itself.

Since the July interest rate decision, yields on long-term U.S. Treasury bonds have continued to rise, which some market participants attribute to Warsh's communication style. Critics argue that, with inflation having exceeded target for more than five years, he has so far failed to provide a clear and credible roadmap for controlling inflation. The term premium—the extra return investors demand for holding long-term bonds—has consequently increased.

Mark Cabana, head of U.S. interest rate strategy at Bank of America Global Research, said, "Wash's 'firm commitment' to lowering inflation is far from enough for the markets. We need to hear concrete plans from the Fed on how to push inflation down in the face of continued underperformance."

Warsh had previously stated that rising yields were a positive sign that the market was "finding its own way" after the Federal Reserve removed its official forward guidance. However, this statement directly contradicts Bessant's position—who last week, after the Treasury expanded its unplanned bond buybacks, explicitly pointed out that yield levels were diverging from fundamentals.

The Ministry of Finance's "Operation Twist" has quietly reshaped the debt structure.

Last week's Treasury bond buyback operation was part of a broader debt management transformation. The Treasury announced that it would double the size of its buybacks of long-term, illiquid bonds starting in September, with an additional $16 billion per quarter. This operation will be funded by issuing new short-term Treasury bills (T-bills), which the market has characterized as an "Operation Twist" that shifts funds from the long end to the short end of the money supply.

In fact, a larger-scale twist operation has already been underway. The Treasury continues to hold routine auctions of long-term bonds while significantly increasing the issuance of short-term Treasury bonds to meet new borrowing needs. An additional $500 billion in short-term Treasury bonds is expected to be issued this year, and if the scale of long-term bond auctions does not expand accordingly, this figure will exceed $1 trillion by 2028.

The concentration of debt in the short term means that the Federal Reserve faces significantly increased pressure to maintain low interest rates. Cabana points out that if Warsh can achieve low interest rates through a combination of productivity-driven growth and low inflation, the United States could save trillions of dollars in interest payments.

However, the current situation is not optimistic. The impact of the Middle East situation has led to an overall upward trend in inflation this year, and some policymakers have clearly indicated a preference for raising interest rates. Current market pricing shows a 78% probability of a rate hike this year, which clearly conflicts with the logic of relying on short-term debt.

Furthermore, whether sufficient demand can be found for short-term debt is itself a problem. Bessant is viewing stablecoins as a crucial support for the demand side—issuers are legally required to purchase U.S. Treasury bonds, and the stablecoin market, currently valued at approximately $300 billion, is projected to grow rapidly. Given the theme of this year's Jackson Hole conference and the formal legislative context of the Genius Act, discussions on this issue are expected to be a major focus.

The direction of balance sheet contraction remains uncertain, and coordinating demand is forcing policy alignment.

While the Treasury increased the supply of short-term Treasury bonds, the Federal Reserve had been purchasing T-bills through its Reserve Management Purchases (RMPs) mechanism to maintain the ample reserve levels necessary for the smooth operation of the repurchase market. This year, it was originally expected to purchase $200 billion to $300 billion in short-term Treasury bonds.

However, the New York Fed announced several weeks ago that its Reserve Investor Programs (RMPs) would be reduced to zero between mid-August and mid-September. Cabana commented, "Currently, funding conditions are ample, which explains the Fed's pause on RMPs. But I expect purchases to resume in the second half of the year to match the balance sheet expansion needed for economic growth and bank credit expansion."

The long-term trajectory of the Federal Reserve's balance sheet remains highly uncertain. The working group established by Warsh is expected to submit its recommendations for balance sheet reduction by the end of the year. Michael Cloherty, head of U.S. interest rate strategy at CIBC, stated, "Quantitative tightening could begin as early as the end of next year. The first step is to advance revisions to liquidity regulations, which should reduce reserve requirements, pushing them back into an ample range, thus creating conditions for the Fed to reduce its asset purchases."

The Federal Reserve currently holds approximately $1.6 trillion in U.S. Treasury securities with maturities of 10 years or more. If it seeks to reintroduce these assets into the market in the future, it will put further upward pressure on long-term yields. Therefore, Warsh's tone on long-term yields on Friday will itself be an important signal—reflecting the likelihood of a potential "new agreement" actually materializing.

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