A Great Disruption Is Coming To The Fed

Authored by Stephen Blitz, Chief US Economist at TS Lombard,

Treasury/Fed Merger Is Underway

The Fed cut and said “that’s all folks” until the data roll in, but that was no surprise and far less important than the signalling from the return of balance sheet purchases. Their cover story is that the TGA account swells in April, so they need to start buying bills now ($40bn in Jan, more in Feb). The press conference message from Powell is that they are buying because the Fed wants money market rates set by policy, not managed through open market operations (SRF these days). In truth, the return signals that the Fed is ensuring that Treasury spending will be financed without any rate hic-cups. The Fed will smooth out the volatility and keep rates tied to the funds rate. You can forget market signalling to the government that it is spending more than the market can absorb.

Hassett et al lean hard against that view from a philosophic standpoint but will eventually yield to politics and practicalities. Returning volatility to the short end of the market, making market signals matter again, was recently espoused by Dallas Fed Pres. Logan and Fed Vice Chair Bowman. There are no votes on this bill-buying turn coming out of the Dec FOMC meeting, perhaps the FOMC minutes in a few weeks will give us a sense of its unanimity or not (Miran standing in for Hassett).

Philosophy is one thing, financing government is another, and once Hassett is confirmed, Bessent will be his boss.

A “direct” reporting line, day-to-day communication (coordination) with the WH running through Bessent (the unitary theory of the presidency in action).

QE obliterated the Treasury/Fed accord, the Fed and Treasury balance sheets are essentially one and Bessent will have his say (especially because he managed the selection process that got Hassett over the finish line).

What Bessent/Trump want is cheap funding – flood the short end and starve the long end of issuance. Today, the Fed announced it will be there to buy the short end. Put this one in the column for why inflation will be higher in 2026.

There was an interesting shift in the SEPs on the funds rate, but it is as meaningless as Powell’s Jackson Hole Speech on the Fed’s new framework – new management takes over in May. The median view on growth in GDP in 2026 is higher (2.3% vs 1.8%), unemployment is the same (4.4%), but core inflation is lower (2.5% vs 2.6%), so the real funds rate is 90bp vs 80bp in Sep. Against this median backdrop, look into the dot plots for the median funds rate in a year’s time (if we knew Powell’s, we could toss it out). Compared with September, the number of FOMC members seeing the funds rate below 3.5% in 12 months jumped from 11 to 16. Because there is one less seeing the rate below 3%, the median of this subset is still 3.00%-3.25% -- where the market is priced (3.10%) with smidge of a bias to a little less. Let’s call it the Trump discount.

As for the economy, Powell’s press conference suggested more weakness than he is headlining. We got their downward adjustment of 60,000 to monthly payrolls -- 40,000 is a 20,000 decline. This is why they are cutting – several months of negative payrolls always leads to cuts (payrolls lead the economy and the Fed reaction function, not the unemployment rate).

We also heard that if they abstract the inflation data from the tariffs, inflation is really running below 2%. If the coming data confirm this, and the Fed seems to think so without saying so, there may be more cuts than the market is pricing, or the funds rate drops to 3.00%-3.25% sooner. Put this one in the inflation lower column for 2026.

In sum, it is all inflationary unless the economy proves to start the year weaker than currently believed. There is a leaning within the Fed, as hinted by Powell, that this may be the case. If true, then the normal lead/lags of growth, employment, and inflation do generate the median outcome – without having to account for the AI productivity story (oversold by my reckoning).

With the coming boost from fiscal policy, any downturn would be limited, but the inflation story nevertheless takes hold later in 2026, or in 2027 (inflation lags real growth by about a year).

Any forecast, necessarily built around norms of fiscal and, more critically, monetary policy, is tenuous at best.

The great disruption is coming to the Fed and banking more broadly. I hope I am wrong, but hope is never a strategy.

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