“If investors lose confidence in the Fed’s ability to prioritize long-term stablity over short-term politics, the response will be clear in the form of higher yields.“
“The bond market will be the source of the action, it will be the motivator of the change.” That was the quote from our Chief Investment Officer, Brian Friedman, at our 2024 Annual Economic Forum. The theme carried into our 2025 forum as well, as we continued to focus on the growing concern over the unsustainable path of the U.S. fiscal deficit. Simply put, if structural deficit spending continues unchecked and inflation pressures persist, bond investors may begin selling off government debt and demanding higher yields. That market pressure would ultimately force Congress to confront the issue.
Investors can take some reassurance in knowing that the bond market serves as a powerful enforcer of discipline. It not only holds elected officials to account but also acts as a prime arbiter of monetary credibility, helping to protect the Federal Reserve’s independence. If markets begin to sense that the Fed is being influenced by politics, long-term inflation expectations could rise, and Treasury yields would follow.
An independent Federal Reserve is absolutely essential, not just for U.S. capital markets, but for financial markets around the world. In order to understand why, we must first understand the Fed’s role and responsibilities.
The Federal Reserve is the central bank of the United States. Its primary responsibility is to manage the nation’s monetary policy, which means controlling how much money is circulating in the U.S. economy. Before the Federal Reserve was created in 1913, the U.S. experienced frequent and severe financial panics, with recessions occurring every 2 to 3 years and often lasting more than a year (see Chart 1). There was no central authority to stabilize the banking system, manage the money supply, or act as a lender of last resort during crises. The Fed was established to provide that stability and to help smooth out the extreme economic swings that hurt businesses, banks, and workers.
At the core of this mission is the Fed’s dual mandate: to promote maximum employment and maintain stable prices. In practice, this means supporting a strong labor market while keeping inflation under control, with a target of 2% annual inflation. Since World War II, recessions have occurred on average every 6.5 years and typically lasted less than a year, a significant improvement from the more frequent and longer downturns before the Fed’s creation.
To achieve these goals, the Fed uses several tools, the most important is its control over the federal funds rate, which is the overnight rate at which banks lend to one another. When the Fed raises this rate, borrowing becomes more expensive, which tends to reduce bank lending and slow the flow of money through the economy. When the Fed lowers the rate, borrowing becomes cheaper, encouraging banks to lend more and increasing the supply of money. This is one of the main ways the Fed influences inflation, spending, the labor market, and overall economic activity.
While this rate influences short-term borrowing costs, the Fed does not directly control the interest rates that matter most to households and businesses, such as mortgage rates, auto loans, or long-term Treasury yields. These are set by the bond market and reflect investor expectations about inflation, economic growth, and fiscal policy. The Fed can attempt to influence long-term rates by buying Treasury securities, but this approach is typically reserved for times of crisis, like we saw during the Global Financial Crisis and COVID-19 pandemic.
A stable and independent Federal Reserve is essential. It allows policymakers to focus on the long-term health of the economy rather than short-term political concerns. When markets trust that the Fed is acting on its mandate, it helps anchor inflation expectations and sustain confidence in the U.S. financial system.
The Federal Reserve plays a central role in the global financial system as the steward of the U.S. dollar, which is not only the world’s primary reserve currency but also dominates global trade, reserves, and debt issuance (see Chart 2). When the Fed adjusts monetary policy, it does not just impact American investors and households. It sends ripples through economies and markets around the world.
The size and depth of U.S. capital markets also give the Fed an outsized influence. U.S. bond and equity markets are the largest (see Chart 3) and most liquid in the world, attracting global investors who seek safety and stability. When the Fed raises or lowers interest rates, it affects the cost of capital worldwide and influences everything from emerging market currencies to global commodity prices. Nearly all asset prices across the globe are ultimately tied to U.S. Treasury yields, which is why changes in Fed policy or the absence of clear policy can have such far-reaching effects.
Other central banks closely monitor the Fed’s actions because their own currencies, inflation expectations, and capital flows are often affected by what the Fed does. In many ways, the Fed sets the tone for global monetary policy, which makes its independence and credibility essential not just for the United States, but for the entire world.
Imagine a scenario where the government runs massive deficits and the Federal Reserve keeps policy too easy (i.e. lower rates) at the same time. Inflation would likely run rampant, eroding purchasing power and damaging the economy.
The Fed’s ability to act independently, even when doing so is politically unpopular, gives investors’ confidence in the U.S. dollar and Treasury market. That trust forms the foundation of global capital markets, where nearly everything is priced relative to U.S. interest rates.
With football season around the corner, here’s a fitting comparison. Imagine the Denver Broncos are facing a fourth down with 25 yards to go in a critical moment. The Broncos’ owner wants to run a quarterback sneak up the middle, but head coach Sean Payton calls “Gun Right Empty Quizno 52 All Go Special X Shallow Cross.” Payton’s pass play reflects preparation, expertise, and the instinct to dial up the play the situation demands.
The same applies to central banking. The Federal Reserve needs the freedom to make complex, data-driven decisions without political interference. That independence gives markets confidence. Without it, trust unravels quickly. Monetary credibility is not automatic. It must be earned and protected. Independence ensures the Fed can stay focused on what matters most: price stability and full employment.
We do not focus on predicting short-term interest rates. What matters far more is that these decisions are made by an independent institution, regardless of whether the Fed gets it right every time or where you fall on the political spectrum. Despite ongoing concerns about inflation, signs of labor market weakness, and recent speculation about leadership changes at the Federal Reserve, long-term U.S. interest rates have remained relatively range bound. That reflects a continued level of trust in the Federal Reserve’s commitment to its mandate.
Much like the fiscal situation, the bond market will ultimately let us know if that trust begins to fade. If investors lose confidence in the Fed’s ability to prioritize long-term stability over short-term politics, the response will be clear in the form of higher yields.
Sound fiscal policy and a credible central bank are the cornerstones of financial stability. The market can tolerate uncertainty, but not a loss of discipline.
Top Row L to R: Brad Engle, Mike Sullivan, Sebrina Ivey, Christian Lewton, Jason Kitner
Bottom Row L to R: Carin Wagner, Angela Kennedy Lee, Jenny Merges, Brian Friedman, Deirdre Mcguire, Barbara Terrazas, Reed McCoy
