A major change is brewing? The US Treasury will "merge" with the Federal Reserve, and Ben Bernanke is the real "shadow Federal Reserve Chairman"

On Sunday, Stephen Blitz, Chief U.S. Economist at TS Lombard, pointed out in an article that the Federal Reserve is about to undergo a major upheaval. With the lines between the Treasury Department and the Federal Reserve becoming increasingly blurred, the balance sheets of the two institutions are effectively heading towards "merger", with Treasury Secretary Yellen playing a key role in this new structure, essentially becoming the "shadow Fed chair". Blitz stated that the latest policy signals from the Federal Reserve indicate that it is restarting balance sheet purchases, planning to start buying $400 billion of Treasury securities in January and further increase in February. While the official explanation is to address the impending inflation in April and manage money market rates, the essence of this move is that the Federal Reserve is committing to providing financing support for Treasury spending, ensuring that funding for the government's institutions does not experience rate fluctuations. This shift not only means that the Federal Reserve will stabilize market volatility, but it also signals that the market's "spending overload" signal to the government will cease to be effective. In this structure, future policy coordination will be closer, with Yellen having considerable influence. With potential successors like Kevin Hassett possibly entering the Federal Reserve, a "direct reporting line" to the White House via Yellen and the Treasury Department is forming, enabling the Treasury Department to lead financing strategies by injecting liquidity into the short end to lower financing costs. Blitz warned that this strategy aimed at providing cheap funds for the government will lead to higher inflation levels in 2026. Although the Federal Reserve's latest Summary of Economic Projections (SEP) shows a downward revision in core inflation expectations, with fiscal policy stimulus and monetary policy coordination, the inflation story will regain dominance in the next one to two years, brewing a "major upheaval" for the Federal Reserve and the banking industry. Substantive "merger" between the Treasury Department and the Federal Reserve According to Blitz's analysis, the Federal Reserve's decision to resume bond purchases completely changes traditional market rules. Federal Reserve Chair Powell stated in a press conference that buying short-term bonds is because the Fed wants to set money market rates through policy rather than manage them through open market operations. However, Blitz pointed out that the true meaning of this signal is that the Federal Reserve is ensuring that the Treasury's spending is financed and does not cause any rate "blockages". Under this mechanism, the Federal Reserve will be responsible for ensuring the smooth operation tied to policy rates, meaning that the bond market will no longer be able to send warnings to the government - that the market can no longer warn the government that its spending exceeds the market's absorption capacity by pushing up rates. Quantitative easing has long broken the traditional agreement between the Treasury Department and the Federal Reserve, effectively merging their balance sheets. Despite strong philosophical opposition to this view from Dallas Fed President Lorie Logan and Fed Governor Michelle Bowman, advocating for restoring market signals and volatility in the short-end market, Blitz believes that this philosophical stance will ultimately give way to political reality and practical operation. New power structure: Yellen will take the lead Blitz pointed out that once Kevin Hassett is confirmed (as a potential senior Federal Reserve official), Yellen will actually become his "boss". A "unified presidential authority theory" is being put into practice, with daily communication and coordination being directly through Yellen. Given that Yellen led the selection process for relevant candidates, he will have decisive influence in future policy formulation. Yellen and Trump's expectations are for low financing costs - achieved by flooding the short end of the market and restricting long-term issuance. The Federal Reserve's announcement of buying short-term assets is in line with this goal. Blitz believes this is a direct cause of the expected rise in inflation in 2026. Blitz believes Powell's speech on the new framework has lost its substance, as new management will take over in May. It is worth noting the so-called "Trump discount", where the number of FOMC members expecting the federal funds rate to be below 3.5% in 12 months will rise from 11 to 16, compared to September. While market pricing currently leans towards around 3.10%, this change reflects an internal tendency towards lower rates. Outlook: Short-term weakness and long-term inflation At the macroeconomic level, Blitz interpreted Powell's press conference as implying more severe economic weakness than headline data suggest. Nonfarm payroll data was revised down by 60,000, indicating not growth but a decline in reality. This is the reason for the Fed's rate cuts - consecutive months of negative job growth data always lead to rate cuts because job data is the main indicator of the Fed's reaction function. In terms of inflation, excluding tariff factors, the current inflation rate is actually running below 2%. If future data confirms this, the market may see more rate cuts than currently priced, or the federal funds rate could drop faster to the 3.00%-3.25% range. However, this short-term easing bias coexists with long-term inflation risks. Blitz concluded that unless the economy performs worse than expected early in the year, the overall trend is inflationary. With fiscal policy boosting, any economic downturn will be limited, and inflation will rise again later in 2026 or 2027. The reliability of any forecasts based on conventional fiscal and monetary policy norms is currently questionable. This article was originally posted on the "Wall Street Horizons" app, written by Zhao Ying, GMTEight Editor: Song Zhiying.