The United States quietly ignites a battle for the authority to set the "Intrerest Rate"! U.S. Treasury Secretary Yellen and Federal Reserve Chairman Powell compete for power.

On the stage of U.S. economic policy, a silent battle over the authority to formulate monetary policy is quietly unfolding. The U.S. Treasury Department's strategy of increasing the issuance of short-term bonds is substantially undermining the independence of the Federal Reserve (FED), and the authority to formulate monetary policy may, in fact, be transferred to the Treasury. This week, U.S. Treasury Secretary Yellen clearly expressed a preference for relying more on short-term debt financing, a stance that contrasts with her previous criticism of her predecessor's excessive reliance on short-term government bonds, which essentially amounts to a fiscal version of quantitative easing. This will not only stimulate risk asset prices to further deviate from long-term fair value and structurally raise inflation levels but will also severely limit the Federal Reserve's ability to independently formulate anti-inflation monetary policy, creating a fiscally dominant landscape.

1. Why are short-term bonds the "catalyst" for inflation?

In the coming years, rising inflation seems inevitable, and the U.S. Treasury's decision to increase the issuance of short-term debt is likely to become a structural factor driving inflation.

The "monetary nature" of Treasury bills: As debt instruments with maturities of less than one year, Treasury bills have a greater "monetary nature" than long-term bonds. Historical data shows that fluctuations in the proportion of Treasury bills in the total outstanding debt often precede long-term inflation trends, resembling a causal relationship rather than a simple correlation. The onset of the current inflation cycle was signaled by a resurgence in Treasury bill issuance beginning in the mid-2010s, during which the U.S. fiscal deficit first exhibited procyclical growth.

The Amplifying Effect of the Repo Market: In recent years, the explosive growth of the repo market has also magnified the impact of short-term debt. Due to improvements in the clearing mechanism and increased liquidity, repo transactions themselves have become more like currency. Treasury bills can typically achieve zero haircut in repo transactions, thereby enabling higher leverage. These government bonds activated through repos are no longer dormant assets on balance sheets, but have transformed into "quasi-currency" that can drive up asset prices.

Liquidity Stimulus: The choice of issuance strategy has distinctly different impacts on market liquidity. When the annual net bond issuance relative to the fiscal deficit is too high, the stock market often encounters trouble. The bear market in 2022 is a case in point, which prompted then-Treasury Secretary Yellen to release a large amount of Treasury bills in 2023. This move successfully guided money market funds to utilize the Federal Reserve's reverse repurchase agreement (RRP) tool to purchase these short-term bonds, thereby injecting liquidity into the market and driving the stock market recovery. Furthermore, observations show that the issuance of short-term Treasury bills typically has a positive correlation with the growth of Federal Reserve reserves, especially after the pandemic; while the issuance of long-term bonds is negatively correlated with reserves. In short, issuing more long-term bonds squeezes liquidity, while issuing more short-term bonds increases liquidity. Issuing short-term bonds provides the market with a "sweet stimulus," but when the stock market is already at historical highs, with investors' positions crowded and valuations extremely high, the effectiveness of this stimulus may be difficult to sustain.

2. The Era of "Fiscal Dominance" has Arrived, The Federal Reserve is in a Dilemma

For the Federal Reserve, the irrational exuberance of asset prices combined with persistently high consumer inflation, along with a large amount of outstanding short-term debt, constitutes a tricky policy dilemma. Traditionally, central banks would respond to this situation by tightening policy. However, in an economy burdened with a substantial amount of short-term debt, interest rate hikes would almost immediately translate into fiscal tightening, as government borrowing costs would soar. At that point, both the Federal Reserve and the Treasury will face immense pressure to ease policies to offset the impact. Regardless, the ultimate winner will be inflation.

As the outstanding balance of short-term government bonds rises, the Federal Reserve will be constrained in its ability to raise interest rates, increasingly unable to fulfill its complete mission. In contrast, the government's massive deficit and its issuance plans will substantively dominate monetary policy, creating a fiscally driven situation. The market's accustomed independence of monetary policy will be significantly compromised, and this is still the situation before the next Federal Reserve Chairman takes office, who is likely to lean towards the White House's ultra-dovish stance.

It is worth noting that this transition will have profound long-term effects on the market. First, the dollar will become a casualty. Second, as the weighted average maturity of government debt shortens, the yield curve will tend to steepen, which means that long-term financing costs will become more expensive. The possibility of reactivating policy tools such as quantitative easing, yield curve control (YCC), and financial repression to artificially suppress long-term yields will greatly increase. Ultimately, this could become a "victory" for the Treasury. If inflation is high enough, and the government can manage to control its underlying budget deficit, then the debt-to-GDP ratio could indeed fall. However, for the Federal Reserve, this is undoubtedly a painful loss, as its hard-won independence will suffer serious erosion.

3. When the Central Bank Does Not Strike Back: How Powell Fights Against Trump's Barrage

In the past, Federal Reserve Chairman Jerome Powell faced fierce criticism from then-President Trump. Powell's response strategy demonstrated the central bank's way of survival under political pressure:

Rule One: Do not talk about Trump. Powell will avoid direct comments on Trump's criticisms in public and remain silent.

Rule 2: Do not retaliate when provoked. Even when cleverly mentioned in Trump's attacks, Powell merely brushed it off lightly and did not respond directly.

Rule Three: Stick to economic topics and avoid discussing politics. Whenever asked about political pressures, Powell always redirects the focus back to the Federal Reserve's dual mandate: low unemployment and stable inflation. He emphasizes that he will only concentrate on what can be controlled.

Rule Four: Cultivate allies outside the Oval Office. Powell actively visited Capitol Hill, receiving unanimous praise and support from Republican lawmakers. The Federal Reserve has also united internally to defend the Chairman's independence. Former Federal Reserve Chairman Paul Volcker also sent a letter congratulating Powell, stating that he "has performed very well."

Powell's "non-responsiveness" strategy has not only earned The Federal Reserve (FED) respect, but also solidified its independence under political pressure. However, with the arrival of an era dominated by fiscal policies, the independence of The Federal Reserve (FED) will face unprecedented challenges.

Conclusion:

The U.S. Treasury's strategy of increasing short-term bond issuance is quietly changing the landscape of U.S. monetary policy, posing a serious threat to the independence of The Federal Reserve (FED). This could not only drive up inflation but also hinder the FED's ability to respond to economic challenges, ultimately leading to a fiscally dominated situation. In this context, the question of who will truly influence the world's most important interest rates seems to be shifting from FED Chairman Powell to Treasury Secretary Yellen. The far-reaching implications of this power shift will be a key point of observation for the future of the global economy and financial markets.