Trump Is Playing with Federal Reserve Fire

President Trump has made it abundantly clear that he would like to have a low interest rate Federal Reserve. For months now, he has heaped relentless pressure on Fed Chair Jerome Powell to cut interest rates by between one and two percentage points. He has done so even at a time when inflation remains above the Fed's two percent inflation target and sharply higher import tariffs are expected to add to price pressure. Trump is also now threatening to name a dovish replacement for Powell to act as a shadow Federal Reserve well before Powell's term as Fed chair ends in May next year.

In clamoring for a low interest rate Fed, Trump should be careful about that for which he wishes. In the current economic and market context, a low interest rate Fed could trigger a dollar and bond market crisis in the run up to next year's midterm elections.

A crucial point that Trump overlooks is that as far as the economy is concerned, it is the 10-year Treasury bond rate rather than the Fed's fund rate that is of paramount economic importance. It is off the 10-year Treasury rate that mortgage rates, automobile lending rates, and other key loan rates are set. This means that if premature Federal Reserve interest rate cuts lead to higher Treasury bond rates, the economy will be adversely impacted rather than stimulated.

The reason to fear that an overly dovish Fed will lead to higher long-term interest rates is because such a move would be occurring in the context of a troubling state of the country's public finances. Even before Trump began his second term, the country was running a 6.25 percent of GDP budget deficit at a time of close to full employment while the public debt to GDP ratio was around 100 percent. This prompted the Congressional Budget Office (CBO) to warn that by 2034 the public debt in relation to the size of the economy would exceed its end of the Second World War level.

Trump's recently enacted One Big Beautiful Bill will exacerbate an already unsustainable public finance situation. According to the Committee for a Responsible Budget, that bill will add around $ 3.5 trillion to the budget deficit over the next decade. In turn, that will take the public debt to GDP ratio to a record high of 127 percent by 2034.

The poor state of America's public finances is already causing foreign investors to question America's economic exceptionality. Long dated US Treasury yields have remained high even at a time of market volatility when investors would normally seek the safe haven of the US Treasury bond market. Meanwhile, since the start of the year, the dollar has lost 10 percent in value, marking its worst first half year performance since 1973 while the price of gold has increased by around 25 percent to its present level of $3,350 an ounce. The dollar's recent decline is of considerable concern in that it has occurred at a time when one would have expected it to appreciate on the back of the increase in import tariffs to their highest level in 100 years and the widening in the short-term interest rate spread in favor of the United States.

In these circumstances, Trump's efforts to create a dovish Fed risk confirming foreign investor's worst fears that the United States intends to renege on its debt commitments either by trying to inflate its debt away or else by forcing foreign creditors to convert their bonds into 100-year zero coupon as is being contemplated in the proposed Mar-a-Lago accord. That will induce those investors to dump their Treasury bond holdings and to flee from the dollar. The net result could be higher long-term government borrowing costs that would worsen an already bad budget outlook. It could also be a further weakening in the dollar that would add to domestic inflation.

Before going down the path of undermining the Fed's independence, Trump would be well advised to take a close look at Turkish President Erdogan's recent sorry experience with forcing the Bank of Turkey to cut interest rates. That experiment contributed to a Turkish currency crisis, sharply higher inflation, and increased government borrowing costs. Trump might also want to reflect on the fact that since September 2024, while the Fed has cut its interest rate by 100 basis points, the 10-year Treasury bond rate has risen by around 60 basis points to its present level of 4.4 percent.

Learn more: Letter: Push for Lower Rates Risks Higher Borrowing Costs | Trump Import Tariff Policy Follies | The End of America's Exorbitant Privilege | How Trump's Tax Cuts Could Start a Financial Crisis

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