Warsh's dilemma: He wants to lower interest rates but fears inflation, he wants to raise interest rates but fears debt—what else can the Fed do?
2026-05-26 09:19:11
With the start of the Kevin Warsh era, a debate has begun regarding the current state of the Federal Reserve and where the new chairman should lead the central bank.
David Andorfato, professor and chair of the Department of Economics at the University of Miami, points out that one of the biggest problems the Federal Reserve will face in the Warsh era is the interplay between monetary and fiscal forces. He warns that aggressively raising interest rates to curb inflation could backfire, especially given the current backdrop of a widening US fiscal deficit.
Professor Andorra Fato has an distinguished academic career, receiving a Bank of Canada Fellowship in 2009 for his contributions to monetary, banking, and monetary policy theory. That same year, he joined the Federal Reserve System, serving as Vice President of Research at the St. Louis Fed, later rising to Senior Vice President, and serving as a senior policy advisor to then-President and President James Bullard. From 2021 to 2022, he served as a special advisor to Federal Reserve Governor Chris Waller. In 2022, he joined the University of Miami's Herbert School of Business as Professor of Economics and Chair of the Department.
Andorra Fato's warning reveals a deep structural dilemma facing the Federal Reserve: the increasingly sharp contradiction between monetary and fiscal policies. With the US federal debt exceeding $39 trillion, government interest payments have become one of the fastest-growing items in the budget. When the Fed raises interest rates to curb inflation, it is essentially simultaneously pushing up the government's refinancing costs: the Treasury is forced to issue new debt at higher interest rates to repay maturing debt, leading to further inflationary interest payments and creating a vicious cycle of "interest rate hikes → increased interest rates → more debt issuance → rising inflationary pressures."
JPMorgan Chase CEO Jamie Dimon also warned that the U.S. government debt is $30 trillion, with an average financing rate of about 3.5%. "Even under today's circumstances, it is almost impossible for the U.S. government to refinance at a lower interest rate," he said, adding that about $2 trillion in debt still needs to be dealt with this year.
From a broader perspective, this dilemma is known to economists as "fiscal dominance"—when government debt is high, the central bank's monetary policy is no longer independent, but is forced to serve the financing needs of the government.
Andorra Fato points out that while aggressive interest rate hikes can curb demand and reduce inflation in the short term, their long-term effects may be counterproductive given the massive debt stock. Higher interest rates increase private sector interest income (primarily through pension funds and corporate profits), and this nominal wealth may ultimately be consumed, thus fueling inflation in a fully employed economy. This means that the Federal Reserve's anti-inflation tools are inherently self-defeating—the more aggressive the rate hikes, the heavier the government debt burden, and the greater the risk of future inflationary rebounds.
More alarmingly, this mechanism of "interest rate hikes pushing up debt costs" has triggered widespread market concerns about fiscal sustainability. Recently, long-term government bond yields in major developed economies such as the US, UK, Germany, France, and Japan have risen rapidly in tandem, and the market is shifting from the past assumption of a "safe asset premium" for sovereign bonds to demanding a "fiscal risk premium."
Investors are demanding higher yields to hedge against the risk that sovereign nations may dilute their debt through inflation or even default in the future.
The Peter Peterson Foundation statement also emphasized that if the average Treasury yield is one percentage point higher than the Congressional Budget Office's projections, interest payments will increase by nearly $2 trillion over the next decade, "meaning less resources will be available for critical national priorities." Under this new paradigm of "debt-driven interest rates," central bank policy autonomy is being eroded like never before, and the challenge of the Warsh era lies precisely in whether the Federal Reserve can maintain its inflation target as fiscal constraints tighten.
Andorra Fato believes the Federal Reserve cannot permanently control inflation through interest rates alone; fiscal policy must play a supporting role. He states that Fed officials need to communicate the consequences of fiscal actions to Congress, advocating a balanced approach that addresses inflationary pressures while avoiding damage to the economy.
This view subtly echoes Warsh's own stance—in his inaugural address, Warsh explicitly stated his intention to lead a "reform-oriented" Federal Reserve, emphasizing the need to rebuild the credibility of monetary policy through balance sheet reduction. Warsh's fundamental judgment is that AI-driven productivity gains are expected to support economic growth without pushing up inflation, thus creating room for a policy combination of "balance sheet reduction + interest rate cuts."
But as Andorra Fato points out, "hope is not policy"—supply shocks have clouded the inflation outlook, which in itself may be the reason why the Fed is taking a wait-and-see approach to raising interest rates.
In fact, Warsh faces extremely severe practical constraints. The market's probability of a Fed rate hike this year has risen to nearly 70%, core PCE inflation remains above 3%, while Warsh's preferred cut-off mean inflation is only around 2.4%. If Warsh rashly pushes for a rate cut at the June FOMC meeting, it could easily be interpreted by the market as a compromise to political pressure, thereby damaging the Fed's hard-won independence. Therefore, Warsh is more likely to adopt a strategy of maintaining interest rates unchanged at the June meeting, while pushing for the removal of the "dodging bias" wording from the policy statement, thereby sending a signal to the market of "data dependence" rather than "pre-set dovishness."
Andorra Fato emphasized that the Federal Reserve must clearly communicate the consequences of fiscal actions to Congress. This means that coordination between the Federal Reserve and the Treasury will become more crucial than ever during Warsh's era. Warsh long advocated for a "new version of the 1951 Agreement" to redefine the relationship between the Federal Reserve and the Treasury—the original agreement ended the Treasury's demands for low interest rates from the Federal Reserve and solidified the bottom line of "money not yielding to fiscal policy." Now, facing ever-expanding debt and persistent inflationary pressures, Warsh may need to re-establish this principle while simultaneously pushing Congress to recognize that without fiscal discipline, monetary policy's efforts to combat inflation will ultimately be less effective.
In conclusion, Andorra Fato believes that in the Warsh era, the Federal Reserve will have to pay closer attention to the constraints of fiscal policy on monetary policy. Aggressive interest rate hikes could backfire in an environment of high debt. Ultimately, the Fed must convey a message to Congress: inflation cannot be sustainably controlled until elected officials make the necessary changes to fiscal policy. "That's what I will do," he said, "but in a respectful manner, acknowledging that the final decision rests with them, and simply clearly telling them: what the economic consequences of your fiscal policies will be, and what they mean for interest rates and inflation."
David Andorfato, professor and chair of the Department of Economics at the University of Miami, points out that one of the biggest problems the Federal Reserve will face in the Warsh era is the interplay between monetary and fiscal forces. He warns that aggressively raising interest rates to curb inflation could backfire, especially given the current backdrop of a widening US fiscal deficit.
Academic and Policy Background: From the Federal Reserve Bank of St. Louis to the University of Miami
Professor Andorra Fato has an distinguished academic career, receiving a Bank of Canada Fellowship in 2009 for his contributions to monetary, banking, and monetary policy theory. That same year, he joined the Federal Reserve System, serving as Vice President of Research at the St. Louis Fed, later rising to Senior Vice President, and serving as a senior policy advisor to then-President and President James Bullard. From 2021 to 2022, he served as a special advisor to Federal Reserve Governor Chris Waller. In 2022, he joined the University of Miami's Herbert School of Business as Professor of Economics and Chair of the Department.
Key takeaway: Interest rate hikes have direct budgetary consequences; aggressive rate increases may backfire.
Andorra Fato's warning reveals a deep structural dilemma facing the Federal Reserve: the increasingly sharp contradiction between monetary and fiscal policies. With the US federal debt exceeding $39 trillion, government interest payments have become one of the fastest-growing items in the budget. When the Fed raises interest rates to curb inflation, it is essentially simultaneously pushing up the government's refinancing costs: the Treasury is forced to issue new debt at higher interest rates to repay maturing debt, leading to further inflationary interest payments and creating a vicious cycle of "interest rate hikes → increased interest rates → more debt issuance → rising inflationary pressures."
JPMorgan Chase CEO Jamie Dimon also warned that the U.S. government debt is $30 trillion, with an average financing rate of about 3.5%. "Even under today's circumstances, it is almost impossible for the U.S. government to refinance at a lower interest rate," he said, adding that about $2 trillion in debt still needs to be dealt with this year.
From a broader perspective, this dilemma is known to economists as "fiscal dominance"—when government debt is high, the central bank's monetary policy is no longer independent, but is forced to serve the financing needs of the government.
Andorra Fato points out that while aggressive interest rate hikes can curb demand and reduce inflation in the short term, their long-term effects may be counterproductive given the massive debt stock. Higher interest rates increase private sector interest income (primarily through pension funds and corporate profits), and this nominal wealth may ultimately be consumed, thus fueling inflation in a fully employed economy. This means that the Federal Reserve's anti-inflation tools are inherently self-defeating—the more aggressive the rate hikes, the heavier the government debt burden, and the greater the risk of future inflationary rebounds.
More alarmingly, this mechanism of "interest rate hikes pushing up debt costs" has triggered widespread market concerns about fiscal sustainability. Recently, long-term government bond yields in major developed economies such as the US, UK, Germany, France, and Japan have risen rapidly in tandem, and the market is shifting from the past assumption of a "safe asset premium" for sovereign bonds to demanding a "fiscal risk premium."
Investors are demanding higher yields to hedge against the risk that sovereign nations may dilute their debt through inflation or even default in the future.
The Peter Peterson Foundation statement also emphasized that if the average Treasury yield is one percentage point higher than the Congressional Budget Office's projections, interest payments will increase by nearly $2 trillion over the next decade, "meaning less resources will be available for critical national priorities." Under this new paradigm of "debt-driven interest rates," central bank policy autonomy is being eroded like never before, and the challenge of the Warsh era lies precisely in whether the Federal Reserve can maintain its inflation target as fiscal constraints tighten.
Policy Recommendation: The Federal Reserve needs to communicate the consequences of its fiscal actions to Congress.
Andorra Fato believes the Federal Reserve cannot permanently control inflation through interest rates alone; fiscal policy must play a supporting role. He states that Fed officials need to communicate the consequences of fiscal actions to Congress, advocating a balanced approach that addresses inflationary pressures while avoiding damage to the economy.
This view subtly echoes Warsh's own stance—in his inaugural address, Warsh explicitly stated his intention to lead a "reform-oriented" Federal Reserve, emphasizing the need to rebuild the credibility of monetary policy through balance sheet reduction. Warsh's fundamental judgment is that AI-driven productivity gains are expected to support economic growth without pushing up inflation, thus creating room for a policy combination of "balance sheet reduction + interest rate cuts."
But as Andorra Fato points out, "hope is not policy"—supply shocks have clouded the inflation outlook, which in itself may be the reason why the Fed is taking a wait-and-see approach to raising interest rates.
In fact, Warsh faces extremely severe practical constraints. The market's probability of a Fed rate hike this year has risen to nearly 70%, core PCE inflation remains above 3%, while Warsh's preferred cut-off mean inflation is only around 2.4%. If Warsh rashly pushes for a rate cut at the June FOMC meeting, it could easily be interpreted by the market as a compromise to political pressure, thereby damaging the Fed's hard-won independence. Therefore, Warsh is more likely to adopt a strategy of maintaining interest rates unchanged at the June meeting, while pushing for the removal of the "dodging bias" wording from the policy statement, thereby sending a signal to the market of "data dependence" rather than "pre-set dovishness."
Andorra Fato emphasized that the Federal Reserve must clearly communicate the consequences of fiscal actions to Congress. This means that coordination between the Federal Reserve and the Treasury will become more crucial than ever during Warsh's era. Warsh long advocated for a "new version of the 1951 Agreement" to redefine the relationship between the Federal Reserve and the Treasury—the original agreement ended the Treasury's demands for low interest rates from the Federal Reserve and solidified the bottom line of "money not yielding to fiscal policy." Now, facing ever-expanding debt and persistent inflationary pressures, Warsh may need to re-establish this principle while simultaneously pushing Congress to recognize that without fiscal discipline, monetary policy's efforts to combat inflation will ultimately be less effective.
The Federal Reserve needs to communicate with Congress; fiscal consolidation is key to controlling inflation.
In conclusion, Andorra Fato believes that in the Warsh era, the Federal Reserve will have to pay closer attention to the constraints of fiscal policy on monetary policy. Aggressive interest rate hikes could backfire in an environment of high debt. Ultimately, the Fed must convey a message to Congress: inflation cannot be sustainably controlled until elected officials make the necessary changes to fiscal policy. "That's what I will do," he said, "but in a respectful manner, acknowledging that the final decision rests with them, and simply clearly telling them: what the economic consequences of your fiscal policies will be, and what they mean for interest rates and inflation."
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