The "Greenspan conundrum" reappears, could Waller use interest rate hikes to exchange for a decline in long-term rates?

Author: Wall Street Journal

The new chairman of the Federal Reserve, Waller, is facing a historically resonant policy question: raising interest rates may actually lower long-term rates, thereby achieving the Trump administration's long-held goal of reducing mortgage rates.

As the Federal Reserve's interest rate meeting approaches this week, the bond market has priced in a 38% probability of an increase in the federal funds rate target, a significant jump from less than 10% before Waller attended the Senate Banking Committee hearing. Bloomberg's economic research sentiment index for Federal Reserve officials shows that the current decision-making body is the most hawkish since the beginning of the 2023 rate hike cycle, with a clear hawkish tendency among seven voting members.

Although this rate hike is not the baseline scenario, this logic is quietly circulating in the market: If Waller consolidates anti-inflation credibility through a rate hike, it may compress the inflation premium embedded in long-term rates, thereby driving down borrowing costs for mortgages, auto loans, and other real lending costs—this is precisely the outcome the White House truly desires.

Policy Insights from the "Greenspan Dilemma"

This logic is not without precedent; history has examples. The late Federal Reserve Chairman Alan Greenspan faced a similar situation in 2004: The Federal Reserve raised the federal funds rate target from 1% to 4.75% by early 2006, yet long-term bond yields fell instead of rising, with the 30-year mortgage rate dropping from a high of 6.34% in mid-2004 to a low of 5.47% a year later. This phenomenon later became known as the "Greenspan Dilemma."

However, Bloomberg Opinion Executive Editor Robert Burgess pointed out that this is less of a "dilemma" and more a reflection of the market's forward pricing mechanism—each rate hike reinforces investors' judgments about the central bank's commitment to anti-inflation, leading to downward pressure on long-term rates.

Treasury Secretary Bessent is not unfamiliar with this logic. He clearly stated early last year that his and Trump's policy focus is on lowering long-term rates, rather than pushing the Federal Reserve to lower short-term target rates. Wells Fargo Securities Chief Economist Tom Porcelli also highlighted this thinking in a report to clients last week: "We frequently hear from those who believe the Federal Reserve will raise rates soon that Waller can achieve the outcome he and Bessent truly want—lower long-term rates—through a rate hike. The logic is that a rate hike will strengthen Waller's anti-inflation credibility and compress the inflation premium embedded in long-term rates."

Waller's Hawkish Stance and Expression of Independence

Since taking over the Federal Reserve from Powell in May, Waller has consistently conveyed a tough stance to the outside world. At the Senate Banking Committee hearing on July 15, when pressed about whether he communicates with Trump, Waller made it clear:

"I have repeatedly told the president and the Treasury Secretary the same thing: they chose an independent person to do an independent job, and that is exactly my plan."

Bloomberg Economics commented on this hearing, stating that Waller "unabashedly displayed a hawkish stance," believing that after inflation exceeded the Federal Reserve's 2% target for 63 consecutive months, the task of achieving price stability is more severe than that of full employment. Waller also pointed out that the construction of artificial intelligence infrastructure is exacerbating inflationary pressures, as the speed of demand shocks is outpacing the supply side's response.

Notably, as soon as Waller finished speaking, the yield on the 10-year U.S. Treasury bond fell sharply, marking the largest single-day drop in three weeks—creating a micro-version of the "Greenspan Dilemma," where hawkish statements led to lower long-term rates.

The New Chairman's Rate Hike Tradition and Current Constraints

Historical practices are also worth examining. According to research by TS Lombard strategist Dario Perkins, Paul Volcker initiated a rate hike less than two months after taking office as Federal Reserve Chairman, while Greenspan, Ben Bernanke, and Powell all took action within a month of their appointments; only Yellen is an exception—she did not raise rates until 22 months into her tenure. Perkins wrote in a report to clients:

"Newcomers always start with a hawkish stance, which helps establish anti-inflation credibility. Volcker once summed up this atmosphere when welcoming Greenspan's first rate hike, saying: 'Congratulations—you are now a real central bank chairman.'"

However, the reality of constraints cannot be ignored. The latest inflation data shows that price pressures have eased, and the five working groups established by Waller are conducting a comprehensive review of the Federal Reserve's operations, with results expected to be announced by the end of the year—tightening monetary policy suddenly before the review conclusions are released would be a delicate timing choice. Additionally, Waller holds only one vote on the Federal Open Market Committee, and changing the policy rate requires seven votes in favor.

Nevertheless, against the backdrop of several committee members hinting that further tightening may be necessary, this threshold may not be as difficult to overcome as it appears. Even if there is no rate hike this week, the mainstream market judgment is that Waller is systematically strengthening his anti-inflation credibility, which itself may already be the most powerful precondition for lowering long-term rates.