The grace period is over. For the first time, US President Donald Trump is demanding explicit interest rate cuts from Fed Chairman Kevin Warsh - exactly what he had asked of his predecessor Jerome Powell.
At the same time, Trump is threatening the US Federal Reserve. If it doesn't lower interest rates, he wants to stop trade with all countries with which the US has a trade deficit. According to the analysis house Kobeissi, that would be almost half of all trading partners, including Mexico, China and Taiwan.
Interrupted supply chains would make imports more scarce and thus cause prices to rise: interest rate increases instead of decreases would be appropriate. A number of US central bankers are also pushing for this. Strong labor market data from Friday reinforced their demand.
Warsh doesn't really have any good options. If he lowers interest rates, as Trump demanded, this is likely to increase prices. If the Fed chief leaves interest rates unchanged, he also risks rising inflation due to the possible trading halt. But rising interest rates also bring disadvantages.
The current situation shows how frayed the nerves are before the congressional elections in November. “The high cost of living is now the focus again. And especially affordable housing,” said capital market expert Mohamed El-Erian in an interview with Handelsblatt. Mortgage interest rates are based on the important yields on ten-year government securities. And last week they climbed to their highest level in almost two years.
Lower interest rates would perhaps push down yields on short-dated government bonds for a while. But they could exacerbate longer-term inflation concerns and thus increase yields on longer-term government securities. With the announced bond buyback program, Finance Minister Scott Bessent actually wanted to achieve the opposite.
Rising interest rates would reduce inflation. But so close to the elections they would worsen the mood within the economy and increase the problems on the housing market.
However, a higher interest rate level would also worsen another problem for Bessent. It also typically leads to a stronger dollar. If the US currency continues to appreciate against the yen, new currency interventions will become more likely.
Japan is a major buyer of US government bonds. In order to support its own currency, Japan would have to reduce its holdings. Bessent could prevent this with interventions.
The effects of interventions by the Japanese and American treasury ministries in the summer quickly dissipated. But a new offensive from Japan has meant that the yen has just stabilized somewhat against the dollar.
Leaving interest rates at the current level of 3.5 to 3.75 percent in the next decision on September 16th seems to be the best solution, at least for the time being. The consequences of a trade stop would be so serious that Warsh is apparently betting that Trump is bluffing and will soon move on to other topics.
