Why Trump’s push for a 1% Fed policy rate could spell trouble for U.S. economy

U.S. President Donald Trump shakes hands with Federal Reserve board member Jerome Powell in the Rose Garden of the White House in Washington, on Nov. 2, 2017. (Alex Brandon / AP)

U.S. President Donald Trump says the U.S. Federal Reserve should set its benchmark interest rate at one per cent to lower government borrowing costs, allowing the administration to finance the high and rising deficits expected from his spending and tax-cut bill.

Trump should be careful what he wishes for.

A Fed policy rate that low is not typically a sign that the U.S. is the “hottest” country in the world for investment, as Trump has said. It is usually a crisis response to an economy in serious trouble.

The U.S. economy isn’t in that kind of trouble now. But with near-full employment, ongoing economic growth and inflation above the U.S. central bank’s two per cent target, the super-low interest rates Trump seeks could easily backfire if investors in the US$36 trillion Treasury market saw such a move as meaning the Fed had caved to political pressure and cut rates for the wrong reasons.

Congress tasked the Fed with maintaining stable prices and full employment, not making deficit spending cheap, and slashing rates in the current environment could well reignite inflation.

“I am not necessarily convinced that ... if the Fed tomorrow decided we are cutting to 1%, that this would have the traditional impact on long-term interest rates. The bond market fear would be that inflation would reignite and essentially we would have a loss of Fed independence and a de-anchoring of inflation expectations,” said Gregory Daco, chief economist at EY-Parthenon. Though there is “scope to ease” from the current 4.25%-4.50% range, it is nothing like the magnitude of cuts Trump envisions, he said.

Daco, noting the unemployment rate is 4.1%, the economy is growing around 2% and inflation is about 2.5%, said: “From a data perspective there is not anything to suggest the need for an immediate and substantial lowering.”

Is 1% normal?

A 1% Fed policy rate has not been uncommon in the last quarter of a century, but is no sign of good times, coinciding with joblessness of 6% or higher.

Former President George W. Bush governed at a time when the rate was 1%. It occurred shortly after the U.S. invaded Iraq in 2003 and at the end of a string of Fed rate cuts following the dot-com crash and the September 11, 2001, attacks on the U.S. Former President Barack Obama inherited a near-zero Fed policy rate when he took office in January 2009. He also inherited a global financial crisis.

Trump himself got the same near-zero interest rate treatment from the Fed in the last months of his first term in the White House - when the COVID-19 pandemic shut down the economy.

What the Fed controls, and doesn’t

While hugely influential, the Fed has limited tools to influence the economy in normal times.

U.S. central bankers meet typically eight times a year to set what is called the federal funds rate.

Only banks borrow overnight at that rate, but it is a benchmark for other credit, influencing everything from corporate debt to home mortgages, consumer credit cards, and Treasury yields. Perhaps as importantly, it shapes expectations about where rates are headed.

While closely correlated with the Fed’s policy rate, those other rates are not set directly by the central bank. There’s always a spread, including for what’s been top of mind for Trump: the interest rate on U.S. Treasuries.

Supply, demand and risk

Global trading across an array of markets ultimately determines those other rates. A foreign pension fund’s demand for Treasuries or mortgage-backed securities, for instance, influences what Americans pay for a mortgage or the U.S. government pays to finance its operations.

Supply and demand are critical.

U.S. government debt supply is determined by spending and tax levels set by the president and Congress. The federal government typically spends more each year than what it receives in tax collections and other revenue, and Treasury covers that annual deficit with borrowed money, issuing securities due in as few as 30 days to as long as 30 years.

All things equal, larger deficits and more accumulated debt mean higher interest rates. Deficits and debt are expected to rise following the passage in Congress earlier this month of Trump’s “One Big Beautiful Bill Act.”

On the demand side, the U.S. enjoys a privileged position that holds down government borrowing costs since it is still considered a relatively risk-free investment with plenty of supply, deep and well-functioning markets and a history of strong institutions and legal norms. Current returns above 4% are particularly attractive for large pension funds or retirees who want income while being assured their investment is safe.

But, like any borrower, the U.S. government must pay a premium for the risk an investor takes on. Locking up money in a 10-year Treasury note means other opportunities are foregone. Rates of interest, inflation and economic growth may all change in that span, and investors want compensation for those risks.

With the Fed policy rate as a starting point, all of those factors are piled on in the form of a “term premium.”

Intangibles, like trust in a country’s institutions, also matter. When Trump’s threats to fire Fed Chair Jerome Powell intensified in April, yields rose and the president backed off - a sign that global markets have an important vote in central bank independence.

Is Fed policy out of line?

Trump recently sent Powell a handwritten note with a list of central bank rates and penciled in where he thought the Fed’s policy rate should be, near the bottom.

U.S. central bank policymakers say it would be risky to cut rates until it is clear that Trump’s new tariffs - many already imposed and more still to come - aren’t going to stoke inflation.

Central bankers often refer to policy formulas or rules that relate their inflation target to incoming and forecasted economic data to point to an appropriate interest rate.

None suggest a Fed policy rate as low as Trump wants.

(Editing by Dan Burns and Paul Simao)