No Fed Rate Cuts Anytime Soon

Donald Trump has made no secret of his hope for early interest rate cuts from Kevin Warsh, the Federal Reserve’s new head. This sets Mr. Trump up for deep disappointment. It is not only that Mr. Warsh does not have the necessary votes on the Federal Reserve’s Open Market Committee (FOMC) to cut rates. It is also that Trump’s war of choice in Iran, coupled with his reckless budget and import tariff policies, offer strong arguments against the appropriateness of an interest rate cut at this juncture.  Start with the fact that there are twelve voting members on the FOMC, of whom Mr. Warsh has only one vote. At its last meeting, many FOMC voting members wanted to remove the “easing bias” language in the Fed’s last interest rate decision. Since then, a majority of FOMC participants have indicated that the Fed may need to raise interest rates later this year if inflation does not cool down to the Fed’s 2 percent inflation target. This makes it highly unlikely that, even if he wanted to do Trump’s bidding, Mr. Warsh will be able to convince his fellow FOMC members to cut interest rates until there is clear evidence that inflation is coming down.  The key reason that most FOMC participants think that an interest rate hike might be warranted later this year is that inflation is currently running at 3.8 percent, or at roughly double the Fed’s inflation target. At the same time, unemployment, at 4.3 percent, remains close to its historically low level. One important factor driving inflation higher has been the spike in gasoline prices from less than $3 a gallon at the start of the Iran war to their current level of around $4.25 a gallon. Other factors have been the hike in import tariffs to their highest level in the past one hundred years and Trump’s large unfunded tax cuts in his One Big Beautiful Bill Act. According to the Congressional Budget Office, those tax cuts will keep the budget deficit at over 6 percent of GDP as far as the eye can see. They will also soon raise the public debt level, in relation to the size of the economy, to its highest level since the end of the Second World War.  The reason to think that inflation is not going to moderate anytime soon is that there is little reason to think that the forces that have caused inflation to pick up over the past year are going to abate quickly. Even if a peace deal is struck with Iran soon, it will take months for oil traffic through the Strait of Hormuz to return to its prewar level. In the absence of an early peace agreement, we could see a further spike in international oil prices. At the same time, the Trump administration is now proposing a 10 percent import tariff on some 60 countries while Trump is proposing a $500 billion increase in the defense budget over the next two years without indicating how that increase is to be funded. Such an increase in defense spending must be expected to exacerbate an already troubling budget position.  There are two strong arguments for no interest rate cuts any time soon. The first is that inflation expectations are rising, which raises the risk that those expectations could become unanchored. According to the University of Michigan, households are now expecting inflation to be as high as 4.8 percent over the coming year. The other argument for maintenance of a tight monetary policy is that the bond market is becoming increasingly concerned about inflation and the country’s unsustainable public finances. This concern is underlined by the fact that the government is now having to pay over 5 percent for borrowing at 30 years. This points to the risk of a full-blown bond market crisis if the Fed is perceived to be not fully committed to meeting its inflation target at a time when the government needs to finance a $2 trillion-a-year budget deficit.  Needless to add, Trump will soon lose patience with Mr. Warsh if he does not deliver interest rate cuts. We have to hope that Mr. Warsh displays the same courage as Jerome Powell did in not bending to Trump’s unrelenting pressure for interest rate cuts. If not, we should brace ourselves for another burst of inflation and the return of the bond market vigilantes.  The post No Fed Rate Cuts Anytime Soon appeared first on American Enterprise Institute - AEI .