10-year U.S. Treasury yield surges to the highest level during Trump's term: An endless war is pushing the Federal Reserve into a corner.

Source: Jinshi Data

The 'Federal Reserve's megaphone,' chief economic reporter Nick Timiraos of The Wall Street Journal, recently wrote that the Federal Reserve's interest rate meeting on September 15-16 is facing an increasingly complex policy environment. The continuously rising energy prices are re-evaluating the central bank's previous judgment that inflation impacts are "transitory," making it harder for investors to believe how long this judgment can hold.

Recently, U.S. Treasury yields have risen in tandem with oil prices, with the 10-year U.S. Treasury yield reaching the highest level during Trump's term. Rising energy costs typically push yields higher through two paths: first, the market anticipates further inflation growth, and second, investors bet that the Federal Reserve will curb price pressures through interest rate hikes.

Federal Reserve Governor Michael Barr further indicated a hawkish stance on Tuesday. He stated that if new data does not show a decrease in price pressures, the Federal Reserve should initiate interest rate hikes this month.

"If inflation does not seem to have sufficiently eased, then I think we should raise interest rates decisively," Barr said in a speech in Washington.

He pointed out that the Federal Reserve had previously aimed to reduce inflation to just above 2% by 2024, but since last year, tariffs, Middle East conflicts, and the development of artificial intelligence have combined to stall the progress of inflation reduction.

Barr's statement also implies that the policy choice at the September meeting may be unusually difficult. Economic and geopolitical changes in the next two weeks could affect the final decision, particularly noteworthy is the inflation report for August scheduled to be released on September 11.

When the Federal Reserve decided to keep interest rates unchanged in July, three officials had already voted in favor of raising rates. Now, the persistent pressure on energy prices has further drawn market attention to policy disagreements at the September meeting.

Oil price shock has not subsided

Federal Reserve Chairman Kevin Warsh mentioned last week while explaining the decision to maintain interest rates in July that policymakers need to observe new information.

He stated that most officials want to assess new information, "especially considering the dynamics that may arise in the areas of supply chains, investment flows, and geopolitics."

By this standard, a prolonged conflict that far exceeds initial expectations and continuously drives up energy prices is hard to view as a short-term variable that can be ignored.

This conflict began at the end of February. Initially, officials and investors generally believed that the resulting energy supply disruptions would last only a few weeks, but six months later, the situation remains unresolved.

Meanwhile, the U.S. inflation rate has exceeded the Federal Reserve's 2% target for five consecutive years. The longer the energy shock lasts, the more likely businesses and workers are to incorporate higher costs and prices into long-term operations and wage arrangements, thus increasing the risk of sustained inflation.

Central banks typically do not respond immediately to energy price shocks with interest rate hikes, as energy prices themselves may retract, and rate increases could further suppress an already impacted economic activity. However, the current issue is that this energy shock has not subsided as initially expected.

The European Central Bank has already raised rates in June and is expected to raise rates again at next week's meeting. The bank currently views rising energy prices as a risk to inflation expectations rather than a short-term factor that can wait to be digested naturally.

The Federal Reserve is also closely monitoring core inflation, which excludes food and energy prices. In the first five months of this year, core inflation has remained above expectations. Although the data in June and July showed improvement, Warsh stated last week that these changes are still not enough to convince him that the underlying inflation trend has improved.

Warsh and Barr have differing judgments

In contrast to Barr's hawkish stance, U.S. Treasury Secretary Janet Yellen believes that recent data actually supports the Federal Reserve's decision to temporarily maintain interest rates unchanged.

In an interview with CNBC, Yellen stated, "I think we are experiencing a supply shock."

She further explained that normally, central banks would not raise rates due to a supply shock unless such a shock begins to produce second or third-order effects; and currently, core inflation remains "very, very contained."

Warsh did not specify how the Federal Reserve would precisely respond to the ongoing energy shock. This is consistent with his long-held policy philosophy: the central bank should derive signals from the market rather than proactively directing the market.

Previously, Warsh stated that rather than allowing investors to trade based on the Federal Reserve's predictions, it is better to let the market draw its own conclusions, as the latter provides more valuable information.

On Monday, Warsh also discussed the global interest rate environment from a longer-term perspective. He and Yellen stated at the G20 summit that the era of so-called global savings glut—where capital was idle due to a lack of investment opportunities—has been replaced by a "global investment boom."

JP Morgan strategists believe this assessment implies that long-term rates may need to be higher than levels seen over the past decade. Although this change has little to do with Federal Reserve policy, investors still interpret Warsh's statements as signals supporting higher rate expectations.

Timiraos noted that the market currently bets that even if the Federal Reserve does not raise rates in September, there may still be a rate hike before December. Regardless of what action is taken in September, the expectation of a rate hike has already been noticeably increased.

If the Federal Reserve raises rates in September, the market's attention will then turn to whether rates will continue to rise, which could further push long-term U.S. Treasury yields higher.

Conversely, if the Federal Reserve chooses to hold steady, new questions will also arise: If Warsh believes inflation has not genuinely improved, and current borrowing conditions do not sufficiently restrain the economy, how should maintaining rates unchanged be explained?

This is precisely the policy dilemma the Federal Reserve faces due to the war's duration exceeding expectations—rising oil prices are no longer just a short-term shock that can be easily waited out.