Kevin Warsh and the interest rate test: Fed decision in the shadow of Donald Trump

Kevin Warsh faces his most delicate decision yet as Fed chief. Inflation speaks for higher interest rates, Donald Trump demands lower ones. Jerome Powell has experienced for years how the US President reacts to resistance from the central bank.

Donald Trump seemed to see the problem coming. "You say everything I want to hear and then you get the job," the US president said in January when he spoke to candidates for the chairmanship of the US Federal Reserve. But as soon as they were in office, Trump predicted at the time, they would suddenly say: "Let's raise interest rates a little." A few days later he decided on Kevin Warsh. Eight months later, exactly what Trump predicted could now happen.

This Wednesday, the US Federal Reserve will decide on key interest rates - and could raise them for the first time in more than three years in view of stubborn inflation. This would put Warsh on a collision course with Trump. The president has been urging the Fed, which is independent of politics, to cut interest rates for months. He is now even threatening to cut off trade with countries with which the US has a deficit if the Fed does not loosen its monetary policy. He did not explain what connection Trump sees between the central bank's course and trade deficits.

Trump demands that the US have “the lowest interest rates in the world.” He envisages key interest rates of 1 percent. The Fed is currently keeping it in a range of 3.5 to 3.75 percent. The US President argues that lower interest rates would provide relief for households, especially when it comes to mortgages, and ease the burden on US debt service.

Meanwhile, pressure is growing on the Fed to combat inflation with higher interest rates. In August consumer prices were 3.4 percent higher than a year earlier. Inflation has been above the Fed's target of two percent for more than five years. Inflation is also being driven by Trump's own policies. His tariffs have increased price pressure, plus the consequences of the war with Iran. The resulting increased energy prices have an impact on the economy.

There will be an election in November

The development comes at a bad time for Trump. The midterm elections will take place in seven weeks, which will decide the majorities in Congress for the second half of his term in office. Polls show growing voter dissatisfaction with the high cost of living. Higher energy prices not only burden drivers, but also drive up the prices of many goods and services through production and transport costs.

Lower interest rates could at least allow Trump to hold out the prospect of economic relief - even if it could take months for it to reach mortgages or credit cards, for example. The Fed points out that its tasks are different. It should contribute to stable prices and full employment.

With high inflation and a robust labor market, opponents of a rate hike at the Fed are gradually running out of arguments. At the most recent interest rate meeting at the end of July, three of twelve monetary authorities with voting rights had already spoken out in favor of an increase. At that time, Warsh voted with the majority for an interest rate break.

Warsh has since announced that the Fed will have to act if inflation does not subside. At the central bankers' meeting in Jackson Hole in August, he described price developments as "increasingly worrying." If it doesn't weaken soon, the Fed will have "work to do."

"Certainly not particularly happy"

Since then, price pressure has increased. Recently, Houthi attacks on Saudi Arabia's infrastructure exacerbated concerns about energy supplies. Oil rose above $100 per barrel again. Over the weekend, diesel cost more than $6 per gallon (3.785 liters) in the USA for the first time, and gasoline remains expensive.

Meanwhile, the White House is increasing the pressure on Warsh. If the Fed raises interest rates, Trump "will certainly not be particularly happy about it," said his economic advisor Kevin Hassett. At the same time, he placed the independence of the central bank in a remarkable way in connection with the upcoming elections. “If you want an independent Fed, one of the things it does is stay out of elections,” Hassett said.

The argument is quite clever: an interest rate increase seven weeks before the midterms can be portrayed as political interference. However, if the Fed were to take the election calendar into account and postpone a necessary interest rate decision, that would be precisely interference in politics.

Pressure on Warsh is also growing from other quarters. An interest rate increase of 0.25 percentage points is now largely priced in on the financial markets. At the beginning of last week the probability was around 50 percent, now it is almost 90 percent. If the Fed were to leave interest rates unchanged despite high price pressure, Warsh's credibility and that of the central bank would be at stake. After all, he had promised a reaction if inflation did not subside.

Attacks on Powell

Added to this is the pressure within the central bank. The Federal Open Market Committee, which Warsh has only chaired since May, places great value on the Fed's independence. Warsh's predecessor Jerome Powell showed how strong the will to distance himself from the White House is at the end of his term in office. He broke with decades of tradition and remained governor of the central bank even after he left the Fed chair. This prevented Trump from filling the seat.

It is unclear how Trump would react to an interest rate increase. So far, the president has kept an option open to take Warsh out of the firing line. The Fed chief wants to “do the right thing” when it comes to interest rates, Trump said. However, Warsh could be prevented from doing so by a "political" and "hostile" FOMC. This would allow Trump to blame an interest rate increase on the other central bankers without breaking with his preferred candidate.

However, how long such a grace period lasts remains to be seen. Trump also made Powell himself Fed chief during his first term in office. Just a few months after he took office, the president began publicly attacking him over his interest rate policy. He later insulted Powell as, among other things, “incompetent,” “idiot,” and “idiot.” After returning to the White House, Trump openly considered firing him. The Justice Department also opened an investigation into Powell over cost overruns in the renovation of the Fed's headquarters. After opposition from Democrats and Republicans, they were discontinued; a federal judge described the action as an abuse of power.

Warsh has so far relied on a different approach to dealing with Trump. While Powell has ostentatiously kept his distance from the White House, Warsh has spoken informally with the president several times since taking office. Observers therefore believe it is possible that his personal connection to Trump will help him politically survive even an interest rate increase.

When Warsh was sworn in in May, Trump expressly encouraged his preferred candidate to be independent. The president said he should be “completely independent.” "Just do your thing." Now it could become clear how serious Trump was about it.