"The Wall Street Journal" senior central bank reporter Greg Ip stated that Trump's demand for interest rate cuts has added a crucial new dimension—he hopes to achieve his fiscal priorities through lower rates. This "fiscal-driven" model often leads to a combination of inflation, crisis, and economic stagnation. However, in the short term, this model may become a powerful economic stimulus, which also explains why the stock market continues to reach new highs under this expectation.
President Trump is pressuring the Federal Reserve to cut interest rates to lower the financing costs of the deficit, a "fiscal-led" strategy currently supported by investors, driving the stock market to new heights. However, veteran central bank reporters warn that such practices are typically associated with weak central banks in Emerging Markets, potentially leading to inflation, crises, and economic stagnation.
On July 5, Wall Street Journal senior central bank reporter Greg Ip published an analysis article, noting that Trump's recent intense requests for Federal Reserve Chairman Powell to reduce interest rates may lead to Powell yielding to someone willing to cut rates. Unlike previous instances, this demand for rate cuts serves fiscal objectives—providing financing support for the recently passed tax cuts by Congress.
The article states that Trump is attempting to break the traditional link between budget deficits and interest rates. Traditional economic theory holds that large-scale borrowing raises interest rates, which offsets the benefits of tax cuts. However, Trump's strategy is to pressure the Federal Reserve to force lower rates to align with his fiscal policy goals.
This "fiscal-led" model has historically been associated with weak central banks in countries like Argentina in Emerging Markets, often resulting in a combination of inflation, crises, and economic stagnation. Nonetheless, in the short term, this model may serve as a powerful economic stimulus, which explains why the stock market continues to reach new highs under such expectations.
The true purpose of Trump's pressure on the Federal Reserve to cut interest rates.
Trump has always claimed to be a "low-interest rate person," but Ip pointed out that his latest requests add a critical new dimension—he hopes to meet his fiscal priorities through lower rates.
To avoid the traditional risk that bond issuance may raise long-term interest rates, Trump's Treasury is trying a new approach. Ip revealed in the article that the Treasury has signaled that bond issuance will favor short-term securities and Treasury bills. The purpose of this action is to avoid the impact of rising long-term rates on government financing costs.
However, this strategy carries risks. If short-term interest rates surge, costs will quickly impact the budget. Trump clearly does not intend to let this happen. As he said on Fox News: "We will let those who can lower interest rates into the Federal Reserve."
"The historical lessons of fiscal dominance."
What is fiscal dominance? Ip explains that fiscal dominance occurs when the central bank shifts its priority from employment and inflation to financing the government. This phenomenon is often associated with emerging markets that have weak central banks, such as Argentina. The results are typically a combination of inflation, crises, and economic stagnation.
However, Ip also points out that reaching that critical point may take years. In the meantime, fiscal dominance could be a strong stimulus factor. While fiscal dominance is not yet the case in the United States, the possibility itself may be influencing the market.
Historically, central banks and government finance have long been intertwined. The Bank of England was established in 1694 to help the monarchy raise funds.
The Federal Reserve assisted government financing during both World War I and World War II, and in the 1960s, it avoided tightening policies to match the Treasury's bond issuance, which fueled inflation.
Since then, the Federal Reserve has avoided clear coordination with fiscal policy. Ip states that the zero interest rates and quantitative easing from 2008 to 2014 were based on the Federal Reserve's independent assessment of the inflation situation, rather than presidential directive, and therefore did not constitute fiscal dominance.
The bond market's reaction and concerns.
Ip provides some key data in the article to illustrate the current fiscal situation. According to the Committee for a Responsible Federal Budget, the House Republicans' initial proposal would increase the deficit from last year's $1.8 trillion (6.4% of GDP) to $2.9 trillion in 2034 (6.8% of GDP).
Even more concerning is that the bill passed on Thursday is even more extravagant: the deficit is set to grow to $3 trillion over ten years, which is 7.1% of GDP. If the temporary tax cuts in the bill are extended, as was the case with the 2017 tax cuts, the deficit would rise to $3.3 trillion, accounting for 7.9%.
However, despite facing such a massive deficit, the U.S. has never run such a large deficit for such a long time, yet the yield on the 10-year Treasury bond has dropped from 4.55% in May to 4.35% on Thursday.
Goldman Sachs economists recently concluded that Powell's successor will not be as concerned about the deficit issue as Powell was, leading to further interest rate cuts in the coming years. This expectation seems to be impacting market pricing.
However, Trump's current threats to the Federal Reserve have not changed investors' expectations for future inflation. Perhaps they believe that no matter what Trump wants, the Fed will remain loyal to its mission. Even if they do not believe this, the cost of fighting the Fed is very high.
Editor/Lee
