National Interest

by Desmond Lachman

    The White House’s spurious criminal case against Federal Reserve Chairman Jerome Powell will raise market fears of mass inflation.

    It would never be a good time for the president to undermine the Federal Reserve’s independence. However, it would seem to be a particularly bad time to do so today. The country’s public finances are in a terrible state, the dollar is on the back foot and President Donald Trump’s import tariff policy is already sowing doubts among foreign investors about America’s reliability as an economic partner. This makes Trump’s most recent frontal attack on Fed chair Jerome Powell particularly ill-advised.

    Anyone doubting that Trump intends to bring the Federal Reserve fully under his control to lower interest rates has not been paying attention. He has repeatedly criticized Federal Reserve Chairman Jerome Powell in public for not drastically reducing interest rates; sought to remove Governor Lisa Cook from the Fed’s board; made new appointments to the Fed’s board who will do his bidding and intimated that he will appoint a monetary policy dove to replace Powell as Fed chair when his term expires in May.

    Now, Trump is stepping up the pressure on the Fed by taking the unprecedented step of having the Department of Justice bring criminal charges against Powell for allegedly misleading Congress about a $2.5 billion renovation project. Trump seems to be doing so to send a signal to Powell’s future replacement as well as to remove Powell from the Fed’s board after his term as Fed chair expires.

    The clear danger of undermining the Fed’s independence is that it could lead to a rise in inflationary expectations. It could do so as investors come to believe that the Fed’s primary goal is to satisfy Trump’s quest for lower interest rates rather than to meet its 2 percent inflation target. In turn, that could lead investors to demand higher US Treasury bond yields to protect them against the prospect of higher inflation.

    A key point that seems to elude Trump is that the Fed’s short-term interest rate is not the most important rate for the economy, but rather the 10-year Treasury bond rate. That rate is crucial for setting mortgage, automobile and other key borrowing rates in the economy. Forcing the Fed to lower its interest rate irresponsibly can have the perverse effect of increasing rather than reducing long-term interest rates. That could constitute a headwind to the economic recovery.

    All one needs to do is look at our recent experience with the Fed cutting interest rates to see how long-term interest rates can move in the opposite direction of the Fed’s short-term interest rate. Since September 2024, the Fed has cut its interest rate by 175 basis points from 5.25–5.50 percent to 3.50–3.75 percent. Yet over the same period, the 10-year Treasury bond rate increased by about 50 basis points to its current level of around 4.2 percent.

    One reason to fear that aggressive Fed rate cuts now would lead to considerably higher Treasury bond yields is that those cuts would occur at a time when our public finances are in very poor shape. Our budget deficit is currently running at around 6 percent of GDP, which raises the prospect that our national debt in relation to income will exceed its end-of-World-War-II level by 2034. In addition, Trump is now suggesting that defense spending be increased by $500 billion over the next two years. That threatens to balloon our public debt further. In those circumstances, there is a real risk that investors will send Treasury bond yields soaring as they come to fear that Trump will try to inflate his way out of our public debt problem.

    Another reason to fear that an overly loose Fed at this juncture would cause long-term interest rates to soar is that foreigners are already shying away from the dollar and the US Treasury bond market. Over the past year, the dollar has lost around 10 percent of its value relative to other currencies, gold prices have surged by 65 percent to their present level of $4,600 an ounce and the US yield curve has steepened. With foreign investors already concerned about the safety of their dollar assets due to recent geopolitical events, the last thing we can afford is to have them begin to fear that we are not serious about controlling inflation.

    If we are to be spared the return of the bond market vigilantes, we have to hope that Trump soon backs off from attacking the Fed’s independence. A good place to start would be to drop the charges against Powell and to appoint as Powell’s successor someone who would enjoy the market’s confidence as an inflation hawk.