Why Raising Rates Would Actually Calm Markets | Jim Bianco

Jim Bianco argues that raising rates could calm the bond market if it convinces investors the Federal Reserve is serious about inflation. When investors think the Fed is tolerating inflation, they may sell bonds, driving prices down and yields up; a credible response could ease that pressure and help protect the real value of bondholders’ fixed cash flows. Since September 18, 2024, the Fed has cut rates six times, by a total of 175 basis points, then held rates since December. Yet the 10-year Treasury yield is about 95 basis points above its September 2024 level, and the 30-year yield is roughly 1.25 percentage points higher. Bianco says he has found no other such episode in his 55 years of data.

Inflation, he says, remains above the Fed’s 2% target: it has been above 2% for 64 months and is currently around 3% to 4%. He characterizes this as low-grade inflation, not an extreme crisis, but says rates may need to reach the 5% range, or closer to 6% in some views, if inflation persists. He expects rates to move higher and does not think moderately higher borrowing costs would impair the economy, while acknowledging housing concerns. He cites 2022, when inflation was near 9% and aggressive Fed hikes helped longer-term yields settle somewhat by signaling that policymakers were alarmed.

There are signs of growing support for a hike, but the committee remains divided. At the July 29 meeting, three officials favored raising rates while nine opposed it, the largest number of same-direction dissents in 10 years; the Fed recorded 10 dissents this year, more than in any of the past couple of decades. Lisa Cook has said she is ready to raise rates, and Bianco thinks as many as five officials could be ready to hike in September, while seven have either ruled it out or remain uncertain. He says decisions are becoming less centered on the chair and more dependent on all 12 voters. The chair can still influence undecided members, but is no longer the only consequential voice.

Bianco expects investors to face less certainty about future Fed moves. Before the July 29 meeting, futures and prediction markets put the chance of a hike at 35% to 40%, an unusually uncertain middle ground. He expects future meetings often to carry hike probabilities between 33% and 66%, as the Fed wants markets to respond to incoming data and price a range of outcomes rather than rely on assurances. He favors guidance that explains which conditions could lead the Fed to raise, hold, or cut rates without promising a specific move. With 12 voters, he cautions, there may be 12 different reaction functions. Forward guidance can also be misread as a promise: Silicon Valley Bank said it held large, unhedged bond positions because it believed the Fed’s assurances that rates would not rise, though Bianco says the bank itself was at fault.

He considers balance-sheet reduction riskier than rate increases for now. Shrinking the Fed’s holdings could create a funding shortage and send repo rates sharply higher; he recalls a prior episode when the repo rate reached 9% after Wall Street could not replace funding withdrawn by the Fed. He says balance-sheet reduction might become feasible in the second half of 2027 or in 2028, after funding-market rules are adjusted and approvals secured. More broadly, Bianco argues that rates should reflect growth, inflation, and borrowing needs, rather than being assumed to be better when lower. If the economy grows 5% to 6%, he says, rates around 5% to 6% can reward investors seeking above-average returns; rates that are too high can choke growth, while rates that are too low can encourage speculation and poor investments.

Near-term inflation pressures may be reinforced by AI-related construction and investment. Bianco describes data-center building as real economic activity, supporting workers in trades as well as demand for chips and other inputs. He cites Alphabet’s planned capital expenditure of $190 billion this year and $1.2 trillion in planned hyperscaler spending, more than the Defense Department’s budget. He expects these costs to sustain higher inflation for the next few years, even though he broadly agrees that AI productivity could eventually be disinflationary. He thinks that effect may not arrive until around 2030, once the economy has integrated the technology more fully; before then, bond investors may sell in response to inflation, pushing rates higher.