Playing with Federal Reserve Fire

When Donald Trump plays with import tariff fire, Wall Street has come to learn that he always chickens out. Hence the name TACO trade or Trump Always Chickens Out Trade. You can always bet that after having threatened to impose an exorbitantly high import tariff on a particular country, he will always back down.

Unfortunately, the same cannot be said when Trump plays with Federal Reserve fire. Rather than backing down, after each of his attacks on the Fed's independence, Trump seems to double down. This does not bode well for the inflation outlook or for the dollar and bond markets especially, at a time when the country's public finances are on an unsustainable path.

All the clues are now pointing in the direction that Trump is well on his way to strip the Fed of its independence and to have a Fed that will do his bidding when it comes to setting interest rates. Since starting his second term, Trump has been publicly browbeating Fed Chair Jerome Powell to reduce interest rates. Indeed, Trump has been calling for interest rates to be cut immediately by three percentage points. He has done so even at a time when inflation has been running consistently above the Fed's two percent inflation target and when Trump's import tariffs are expected to add to inflation.

Trump is also now on his way to getting a majority of his appointees on the Fed's Board of Governors. He will succeed in doing so if he prevails in the courts to have Lisa Cook removed as a governor on the grounds that she engaged in mortgage fraud. More importantly yet, he has narrowed his choices to replace Powell when his term expires in May next year to three candidates who are all monetary policy doves and who will likely do Trump's bidding as Fed Chairs.

If monetary policy independence is an important ingredient of policy to keep inflation expectations well anchored in normal times, it is all the more important in today's circumstances of our unsustainable public finances. According to the Congressional Budget Office, Trump's Big Beautiful Bill will keep the budget deficit in excess of 6.5 percent of GDP for as far as the eye can see. In turn, that will take the public debt to GDP ratio to a Greek-like 128 percent by 2034.

A weakness of the US economy is that it relies heavily on foreigners to finance its budget and trade deficits. Indeed, foreigners currently own $8.5 trillion, or almost a third, of the $28 trillion of all Treasury bonds outstanding. If the Fed's independence is eroded, foreigners will have good reason to fear that the US will go down the path of trying to inflate its way out from under its debt mountain. In turn, that will make them loath to continue financing the US budget deficit. Should that happen, we should brace ourselves for a dollar and bond market crisis that could destabilize our financial system.

Already, there are troubling signs that markets are beginning to lose confidence in the Trump administration's ability to manage the economy in general and to keep inflation at bay in particular. Since the start of the year, the dollar has depreciated by 10 percent despite import tariffs having been raised to their highest level in 100 years and despite a widening of the short-term interest rate differential in the United States' favor. Meanwhile, gold prices have increased by 45 percent, in no small part as a result of central banks shifting out of the dollar to gold in their international reserve holdings. It is also hardly encouraging that US Treasuries appear to have lost their appeal as the world's primary safe-haven asset in times of financial market volatility.

Trump would do well to heed these early warning signs and back off from his crusade against the Fed's independence. If not, as appears all too likely, we should brace ourselves for a dollar and bond market crisis in the run-up to next year's mid-term elections.

Learn more: Is a French Sovereign-Debt Crisis Looming? | The Gold Canary in the Coal Mine | AI Will Collapse Wages | Buckle Up. Bond Turbulence in France Could Spill Into the U.S.

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