Is a major change brewing? The U.S. Treasury will "merge" with the Federal Reserve, and Bessent is the true "shadow Fed Chair."

On Sunday, Stephen Blitz, Chief U.S. Economist at TS Lombard, wrote that the Federal Reserve is about to face a significant disruption. As the boundaries between the Treasury Department and the Federal Reserve become increasingly blurred, the balance sheets of the two institutions are effectively moving towards "merger," with Treasury Secretary Janet Yellen playing a key role in this new structure, becoming the de facto "shadow Fed Chair."

Blitz stated that the latest policy signals from the Federal Reserve indicate that it is restarting balance sheet purchase operations, planning to buy $40 billion in Treasury bills starting in January and further increasing in February. Although the official explanation is to address the expansion of the Treasury General Account (TGA) in April and manage money market rates, the essence of this move is the Federal Reserve's commitment to provide financing support for Treasury expenditures, ensuring that deposit-taking institutions do not experience interest rate fluctuations.

This shift not only means that the Federal Reserve will smooth out market volatility but also signifies that the market's "overload of spending" signal to the government will become ineffective. Under this framework, future policy coordination will be tighter, and Yellen will have significant influence. With potential successors like Kevin Hassett possibly entering the Federal Reserve, a "direct reporting line" to the White House, operated through Yellen, is forming, which will enable the Treasury to dominate financing strategies by injecting liquidity into the short end to lower financing costs.

Blitz warned that this strategy aimed at providing the government with cheap funding will lead to higher inflation levels by 2026. Although the Federal Reserve's current Summary of Economic Projections (SEP) shows a downward adjustment in core inflation expectations, with the stimulus from fiscal policy and coordination with monetary policy, the inflation narrative will re-emerge as a dominant theme in the next year or two, and a "great disruption" targeting the Federal Reserve and the banking sector is brewing.

The Substantive "Merger" of the Treasury and the Federal Reserve

According to Blitz's analysis, the Federal Reserve's resumption of bond purchases fundamentally alters traditional market rules. Federal Reserve Chair Jerome Powell stated at a press conference that the purchase of short-term debt is because the Federal Reserve 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 Treasury expenditures can be financed without causing any "blockages" in interest rates.

In this mechanism, the Federal Reserve will be responsible for the smooth operation linked to policy rates, meaning that the bond market no longer serves as a warning system to the government—i.e., the market can no longer signal to the government that its spending has exceeded the market's absorption capacity by pushing up interest rates. Quantitative easing has long broken the traditional agreement between the Treasury and the Federal Reserve, effectively merging their balance sheets.

Although Dallas Fed President Lorie Logan and Fed Governor Michelle Bowman strongly oppose this view from a philosophical standpoint, advocating for the restoration of market signals and the volatility of the short end market, Blitz believes that this philosophical stance will ultimately yield to political realities and practical operations

New Power Structure: Bessenet Will Take the Lead

Blitz pointed out that once Kevin Hassett is confirmed (as a potential senior Federal Reserve official), Bessenet will effectively become his "boss." A theory of "unitary presidential authority" is being put into practice, meaning that daily communication and coordination will be conducted directly through Bessenet. Given that Bessenet dominated the selection process for relevant candidates, he will have decisive influence in future policy-making.

What Bessenet and Trump expect is cheap financing costs—achieved by flooding the short end of the market and limiting long-end issuance. The Federal Reserve's announcement to purchase short-end assets is precisely to align with this goal. Blitz believes this is one of the direct reasons for the rise in inflation expectations for 2026.

Blitz believes that Powell's remarks about the new framework have lost substantive meaning, as a new management team will take over by May. Notably, the so-called "Trump discount" indicates that the number of FOMC members expecting the federal funds rate to be below 3.5% in 12 months will jump from 11 to 16 compared to September. Although current market pricing leans towards around 3.10%, this change reflects an internal tendency towards lower rates.

Economic Outlook: Short-term Weakness and Long-term Inflation

On a macroeconomic level, Blitz interprets Powell's press conference as suggesting more severe economic weakness than the headline data indicates. Non-farm payroll data was revised down by 60,000, meaning the actual situation is not one of growth but rather a decline. This is precisely the reason for the Federal Reserve's interest rate cuts—several months of negative employment data will always lead to rate cuts, as employment data is the main indicator in the Federal Reserve's reaction function.

Regarding inflation, if tariff factors are excluded, the current inflation rate is actually running below 2%. If future data confirms this, the market may see more rate cuts than currently priced in, or the federal funds rate may drop more quickly to the range of 3.00%-3.25%.

However, this short-term easing tendency coexists with long-term inflation risks. Blitz concluded that unless the economic performance at the beginning of the year is weaker than expected, the overall trend is inflationary. With fiscal policy support, any economic downturn will be limited, and inflation will resurface later in 2026 or in 2027. The reliability of any predictions based on conventional fiscal and monetary policy norms is currently precarious