President Donald Trump is playing with fire by putting pressure on the Federal Reserve to reduce interest rates while at the very time that he is proposing massive tax cuts.
By so doing, he risks the return of the bond vigilantes and a spike in those interest rates that really matter to the economy.
That, in turn, risks creating considerable financial system strain and tipping the economy into recession.
The Interest Game
It seems that the recent strange developments in the bond market have escaped Mr. Trump’s notice. Since September 2024, when it became increasingly clear to the markets that Mr. Trump might win the election, long-term interest rates have spiked when the Fed has been cutting its interest rate.
Indeed, over the past four months, while the Fed cut its interest rate from 4.75 percent to 4.25 percent, the 10-year Treasury bond yield has spiked around 100 basis points from 3.6 percent to 4.6 percent.
The 10-year Treasury bond yield spike is of considerable importance since that is the number that determines the level of mortgage rates and other key interest rates that affect the US economy.
The rise in the long-term interest rate also causes world interest rates to rise, reducing the value of the banking system’s bond and loan portfolio. It is already estimated that the banks have mark-to-market losses well in excess of $1 trillion due to the earlier rise in long-term interest rates that followed the Federal Reserve’s shift to a tight monetary policy to regain inflation control.
Further mark-to-market losses are the last thing the banking system needs at a time when it is facing the real risk of a wave of commercial property loan defaults.
Bond Market Swoon
A key lesson Mr. Trump should be learning from the bond market’s recent swoon is that long-term interest rates are determined by the market’s expectation of future inflation, not by the Fed’s interest rate. Suppose the market comes to believe that the government is following an irresponsible budget policy while the Fed is under political pressure to keep its interest rate low to finance large budget deficits. In that case, the market will expect inflation to rise as a result of economic overheating.
That will force a rise in government bond yields as investors will demand higher interest rates to compensate them for the risk of higher inflation.
If there was a time when the market was right to fear the pursuit of an irresponsible budget policy, it has to be now. At a time when the budget deficit is already at 6 ½ percent of GDP, and the public debt is close to 100 percent of GDP, Mr. Trump is proposing a slew of tax cuts that would exacerbate an already precarious public finance situation.
Among the tax cuts, Mr. Trump has in mind are the extension of the 2017 Tax Cut and Jobs Act and the elimination of income taxes on social security benefits and tips.
According to the Committee for a Responsible Budget, Mr. Trump’s tax cuts would add $7.75 trillion to the budget deficit over the next decade. That, in turn, would result in a rise of the public debt by 2034 to around 140 percent of GDP or to a level that would well exceed that reached at the end of the Second World War.
Little wonder, then, that inflation expectations are rising and that the market is sending long-term interest rates higher.
President of the United States Donald Trump speaking at the 2017 Conservative Political Action Conference (CPAC) in National Harbor, Maryland. Image Credit: Gage Skidmore.
Instead of jaw-boning the Fed to lower interest rates, Mr. Trump would serve the country better by focusing his attention on the dangerous path on which our public finances find themselves. At a minimum, Mr. Trump should back down from his campaign promises to radically cut taxes and come up with some combination of tax reform and public spending cuts to reduce the country’s gaping budget deficit.
If, instead, he chooses to keep his tax cut commitments and to pressure the Fed to cut interest rates, we should brace ourselves for some rough economic sledding later this year.
About the Author: Desmond Lachman
American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.
