The disappointing performance of the Chairman of the Board of Governors of the Federal Reserve, Kevin Warsh, and the Secretary of the Treasure, Scott Bessent, prompts me to return to my favorite topic of inflation, the rate of change in the value of money. Being a monetarist, when discussion inflation I give primary attention to the money supply and its rate of growth.
But monetary policy and inflation are generally linked to interest rates, in particular the Federal Reserve policy rate. President Trump wants it low (the government interest payments on its 40 trillion dollar debt were $1.2 trillion in 2025, more than its War Department budget of $868 billion the same year) but the Fed has kept it unchanged at 3.65% all of this year despite inflation of 3.4% from a year earlier and a target rate of 2%. Since the 2008 financial crisis the Fed’s policy rate has been the rate it pays banks for their deposits at the Fed (Interest on Reserve Balance—IORB).
This note will clarify the relationship between the Fed’s policy interest rate, market interest rate, the money supply and inflation. If these issues don’t interest you, stop reading now and we can still be friends. If they do interest you I will depend on your reading my earlier blogs that provide necessary background. The first point is that while interest rates are determined in the market, the Fed’s influence is indirect. https://wcoats.blog/2025/07/17/the-feds-policy-interest-rate/ https://wcoats.blog/2025/12/13/econ-101-interest-rates/
The main point is that the Fed’s policy rate is the instrument by which it controls the money supply, and the behavior of the money supply is the most important factor determining inflation. If the Fed lowers its policy rate (relative to what economists call the neutral rate), banks will draw down their reserve deposits at the fed and lend more. Thus the money supply will grow more rapidly. As market rates (say on ten-year treasury bills) reflect the balance of saving and investing—the real interest rate—plus the market’s expectation of inflation, an increase in the expected rate of inflation will increase observed nominal market rates. So, if the increase in the rate of money growth from lowering the Fed’s policy rate increases inflation it will increase longer-term market interest rates. https://wcoats.blog/2024/11/08/econ-101-money/
No one has really figured out what Secretary Bessent thinks he is doing with his repurchase of long-term government bonds. He said this was to lower long-term interest rates when in fact it is more likely to increase them if anything. Lowering long-term interest rates requires reducing government debt (less spending or higher taxes), increasing our trade deficit (so that China finances more of our fiscal debt), or lower inflation that reduces the inflation expectation component of market rates. Bessent’s repurchase does none of these. The money he needs for the long-term debt repurchases will need to come from increased borrowing of short term securities. It’s all nonsense.
And then there is Chairman Warsh. I applaud his intention to review how policy is formulated and communicated. He is right to reaffirm the Fed commitment to its 2% inflation target, giving it the pride of place in the Fed’s dual mandate of stable prices and “full” employment. He is right that the Fed’s forward guidance was misunderstood and counterproductive. The Fed should not commit itself to a path of its policy rate in the future. The Fed’s forward guidance should be to do whatever will best achieve its inflation target. The policy rate chosen today (its instrument for controlling the behavior of the money supply) should be the rate the Fed judges, given the current status of the economy and its forecasts for other relevant data, will result in 2% inflation in one to two years.
Let me repeat that. What the Fed needs to confirm to the market is its commitment to set today’s policy interest rate so as, in its best judgment, will produce a 2% inflation rate within one to two years. If conditions change, the Fed may need to change its policy rate. Its only commitment to the future is to do today what it thinks will achieve its inflation target. https://wcoats.blog/2021/08/09/a-shift-in-monetary-regimes/
But to keep the public’s inflation expectations anchored at 2%, the Fed must clearly explain why it thinks its current policy rate will achieve that target. This is where Warsh has stumbled. In his address to the annual Jackson Hole monetary policy gathering Aug. 28th he made significant progress in improving his messaging. https://www.washingtonpost.com/business/2026/08/28/fed-chair-warsh-speaks-jackson-hole-conference/
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