The rhetoric is getting louder. Potential contenders to replace the head of the U.S. central bank are lining up for that coveted position. The president’s demand for lower interest rates is now almost a daily occurrence. Why?
Jerome Powell, the chairman of the U.S. Federal Reserve, is now on President Donald Trump’s naughty list. The White House and its allies have intensified their assault on the Fed chairman. The president is actively asking his allies in Congress if he should fire Powell — if he can. Some members of his administration are using the Fed’s over-budget $2.5 billion headquarters renovation to build a case for removing Powell sooner than next spring, when his term is set to end.
Why now? What is so important that Trump can’t wait a few months before the Fed lowers interest rates anyway?
From a financial perspective, the economy appears to be in no danger of recession. The latest nonfarm payroll report for June was a robust upside surprise, signaling a healthy labor market. Inflation, while down over the last few months, is by no means defeated.
And yet, the administration’s urgency to reduce interest rates is palpable.
Some dismiss the president’s rhetoric by explaining that the president has always been a “low interest rate kind of guy,” which is a legacy of his years as a real estate mogul. OK, I can buy that, but Scott Bessent, the treasury secretary, is a Wall Street money manager. He knows the interest rate market like the back of his hand. He cares deeply about the ramifications of lowering interest rates in today’s economic environment.
U.S. Treasury Secretary Scott Bessent, shown speaking outside the White House in March, said recently that President Trump had instructed him “not to do any debt beyond nine months or so” until a new Fed chair is installed.
Some of Bessent’s recent comments may hold the key to what is really going on. In a recent Bloomberg TV interview, he stated that Trump had instructed him “not to do any debt beyond nine months or so” until a new Fed chair is installed. He explained his reasoning: “Why would we issue debt at current long-term rates?”
With the government’s interest payments exceeding $1 trillion annually, selling longer-term maturities that command higher interest rates would substantially increase those costs.
What this indicates to me is that there has been an essential shift in the country’s policy toward borrowing, away from long-term debt such as 10-, 20- or 30-year Treasury bonds and towards lower-interest, short-dated debt, such as Treasury bills with less than one-year maturities. Why does that matter?
Readers should be aware that interest rates on long-term debt are determined by the market, whereas the Federal Reserve sets those on short-term debt through adjustments to the Fed Funds rate. Historically, the Fed has acted independently of the rest of the government, doing what it thinks best to curb inflation and maintain employment, but times change.
The person who receives the nod to become the next Fed chairman will be determined by two things: his loyalty to the president and his willingness to reduce interest rates. Once appointed, he is expected to be at the beck and call of Trump’s interest rate demands. Given that the president has already instructed the Treasury to focus on issuing debt in the short-term market, the Fed will be able to effectively decide the interest rate the government pays on its debt.
Since interest rate payments are now the second-largest cost item after entitlements, the government’s control of how much it pays for borrowing would save the government billions of dollars in interest expense. Since the issuance of long-term Treasuries is significantly lower, yields on that debt should drop due to supply and demand. However, interest rates on long-term bonds will depend on what the market decides is a fair yield, based on its growth and inflation expectations.
A friendly new Fed chair, working with the Treasury to maintain this new financing mix of lower interest rates and short-dated maturity issuance, could keep the nation’s interest payments in check. In one fell swoop, the Fed and Treasury would reduce the budget deficit and stimulate the economy at the same time.
But what happens if the bond buyers of our long-term debt don’t go along with this scheme? There is a remedy for that as well.
Recall that last year, the Fed cut interest rates by 50 basis points. The short end of the yield curve dropped as expected, but the longer-dated bonds (controlled by the markets) did the opposite. What was behind that rise in interest rates? Financial markets decided that the Fed cut could lead to higher inflation over the long term. Since then, yields on those bonds have remained higher than most expected.
Could that happen under this new regime at the Fed? It could, but there would be nothing to stop a less-independent central bank from buying longer-dated Treasury bonds on its own, thereby driving down long rates as well. They have done it before under the name of quantitative easing. If they wanted, they could even buy long-dated Treasury bonds at auction if needed.
There is a name for this kind of policy change. It’s called “fiscal dominance,” something I witnessed countless times in several emerging market economies back in the day. It is a policy that subordinates a previously independent central bank to the needs of the Treasury. It typically occurs in a government that has abandoned budget discipline and resorts to printing money to finance its deficit. Sound familiar?
During my travels throughout South America in what was known as “the lost decade of the ’80s,” fiscal dominance governments emerged everywhere. Their government leaders opted for stimulating growth this way but ignored the risks of price stability. What occurred was structurally higher inflation, currency debasement, and ultimately, a political crisis.
Can this happen here, and if so, what will be the impact on the financial markets? Next week, we will examine how a potential change in Fed leadership, influenced by the president and the U.S. Treasury, could impact bonds, the dollar, commodities and the stock market.
