Desmond Lachman: New challenges for a new Federal Reserve

Mike Tyson famously said that everyone has a plan until they are punched in the face. We have to wonder whether the same might be said of Donald Trump and the new Federal Reserve Chair Kevin Warsh's plans for the Fed under new leadership.

While Trump and Warsh might want to have the Fed lower interest rates and reduce the size of the Fed's bloated balance sheet, they are receiving two economic punches in the face that will force them to shelve those plans for another day. The first punch is coming from the closure of the Strait of Hormuz. The second is coming from the current U.S. bond market rout.

Start with the inflation shock coming from the Strait of Hormuz's closure. Not only does 20% of the world's oil and natural gas supply pass through that strait. So, too, does 30% of the world's seaborne fertilizer trade, 30% of the world's helium supply, and 10% of the world's aluminum production. Little wonder then that we have seen a 60% surge in international oil prices to around $100 a barrel and a more than 50% increase in world fertilizer prices.

As a result of the strait's closure, we have already seen a more than 50% surge in gasoline prices from less than $3 a gallon to around $4.50 a gallon.

Meanwhile, diesel prices have increased by more than 60%. The current fertilizer shortage is bound to add a food price shock to the current energy price shock later this year. Meanwhile, a prolonged shortfall in helium supply could disrupt semiconductor production, which is all-important in today's manufacturing.

The net result has been that consumer price inflation has already risen to 3.8%, nearly double the Fed's 2% inflation target. Meanwhile, wholesale prices have jumped by 6%. With every prospect that Iran will not relinquish its control of the strait anytime soon, inflation could very well exceed 4% by year's end as oil prices rise above their $100 a barrel level.

With consumers now expecting inflation to run at 4.5% in the year ahead, the Fed would risk allowing inflation expectations to become unanchored if it were to contemplate interest rate cuts at this stage. Understanding the Fed's inflation challenge, markets are now pricing in more than a 50% chance that the Fed will be forced to raise interest rates by year's end.

The second economic punch that Trump and Warsh are receiving is a spike in long-term interest rates. Since the start of the Iran War, the all-important 10-year U.S. Treasury bond yield has surged by more than 50 basis points to around 4.6%. Meanwhile, the 30-year U.S. Treasury bond yield has surged to 5.2%, the highest level since 2007.

It is difficult to overstate how much of a risk the recent long-term interest-rate surge poses to the economy. Those rates are key determinants of mortgage rates, auto loan rates, and many other household and corporate borrowing rates. They could also create problems for financial markets by exacerbating the strains in the $3 trillion private credit market.

One of the factors driving the interest rate spike is the unsustainable path our public finances are on. According to the Congressional Budget Office, our country's budget deficit is set to exceed 6% of GDP as far as the eye can see. That will soon push the public debt level relative to the size of the economy to its highest level since the end of World War II.

Another factor driving long-term interest rates higher is waning investor confidence in the U.S. commitment to low inflation. This is particularly important among foreign investors, who hold around a third of all outstanding Treasury bonds. If they come to fear that the United States is trying to inflate its way out of its debt problem, they could shift from being buyers to sellers of our government bonds.

All of this makes for an inappropriate time for the Fed to try to reduce the size of its balance sheet by selling its large Treasury bond holdings. That would be sure to send long-term interest rates even higher. Indeed, to stem the current rout in the bond market, the Fed may soon need to provide support by buying Treasury bonds again.

English economist John Maynard Keynes famously said, "When the facts change, I change my mind. What do you do, sir?" Now that the economic facts are changing, we have to hope that Trump and Warsh change their mind about what the Fed should now be doing with its interest rate policy and with the size of the Fed's balance sheet. If not, we should brace ourselves for some rough sledding in the economy and financial markets.