The National Memo

12/03/2025

While the link between Fed policy and inflation is somewhat less direct than is often claimed, a Fed that lowers the federal funds rate by almost three full percentage points, when inflation is already one percentage point above the Fed’s target inflation, is not a Fed committed to fighting inflation. People investing billions in bond markets will take this into consideration in their willingness to hold Treasury bonds.

This is even truer in an international context where investors can easily switch their holds to bonds or other assets in foreign currencies. A 1.0 percent short-term yield in U.S. dollars, that might be losing value due to inflation, is not going to look good compared to higher yields in other currencies that look more stable. That story applies even more clearly with longer-term bonds.

This means that we are not likely to see a sharp fall in longer-term interest rates as a result of Chair Hassett’s aggressive rate cut. It’s possible that long rates would even rise as people flee the dollar, causing its value to fall. That would be one route to the higher inflation investors fear, as a sharp fall in the dollar will lead to higher import prices.

Where the economy ends up in this sort of story is difficult to say since we have never been there. Inflation can be slowed, without the Fed’s cooperation, by sharp budget cuts and/or tax increases, but that course seems unlikely with Donald Trump in the White House. Perhaps he will just fire more people at the BLS until he can find someone who will tell us that inflation is over.

I have long ridiculed the promulgators of the “bond market vigilantes” story, where we have investors who will send long-term interest rates through the roof and the dollar plummeting in response to large budget deficits and/or an irresponsible Fed. I would still ridicule them, since many of them say we already are facing a situation that should prompt panic.

But I do believe there is a point where their story is correct. There are countries where investors have no confidence in the government’s ability to limit inflation. Argentina could be the poster child here. They have very high interest rates and weak currencies. Given the strength of the U.S. economy and its importance to the world economy, there is a long way between the United States and Argentina.

However, when you have a government that arbitrarily imposes high tariffs on trading partners, whose trade agreements are worthless, that issues large government contracts for bribes, that deports millions of workers and engages in many other forms of blatant corruption, and whose president routinely makes utterly absurd claims about the economy and the world (has anyone seen the $20 trillion in foreign investment?), we have moved much of the distance towards Argentina. Putting a total hack in as Fed chair, who sets monetary policy based on orders from this president, can get us much of the rest of the way there.