Despite the administration’s best efforts, don’t count on lower rates in Trumpland

John Rapley is a contributing columnist for The Globe and Mail. He is an author and academic whose books include Why Empires Fall and Twilight of the Money Gods.

Pressure on the U.S. Federal Reserve to cut interest rates rises by the day. In addition to Donald Trump’s frequent diatribes against Chairman Jerome Powell, a split has emerged among the governors over the direction of monetary policy. Meanwhile, a recent resignation has given the President an opening to appoint another sympathetic governor, further tilting the balance on the board and giving Mr. Trump an opportunity to trial a “shadow chairman.”

And even before the Fed cuts rates, the administration is using various policy tools to push down borrowing costs. It’s engaging in something called yield curve control, whereby it does most of its borrowing for only a few months (which it then renews); by reducing its issuance of long-term bonds, demand drives up their price, bringing down their yield and resulting in lower interest rates.

In addition, the administration’s aggressive promotion of cryptocurrency and especially stablecoins is further pushing demand for Treasury paper. That’s because stablecoins have to be backed by liquid dollar assets, which in practice means U.S. government bonds.

So, when the growing signs of a slowing economy are added to all these moves to drive down borrowing costs, it becomes a safe bet that interest rates will soon fall. That’s certainly where investors are putting their money, with Fed futures currently pricing an 85-per-cent probability the central bank will cut rates at its September meeting.

Trump to nominate top economic aide Stephen Miran to fill open spot on Federal Reserve board

Trump calls on Federal Reserve board to usurp Powell and take control of central bank

Yet for all that, it may still be too early to bank on interest rates coming down much. For starters, the Fed already cut interest rates in the past year, yet bond rates have since risen – as they have in Canada. That’s because central banks set only short-term rates.

Long-term rates are set in bond markets and are determined by what investors are willing to accept to lend to governments. And with Western governments flooding markets with new bonds as they fund expansive fiscal programs, this has become a buyer’s market. If they don’t like the interest rate on offer, investors can just hold out until they rise – which explains why long-term rates rose after the Bank of England cut interest rates this week.

Meanwhile, the signals from the economy aren’t unambiguous. Several recent reports – the employment report, the GDP report and this week’s ISM surveys of business confidence – all point to a rapidly slowing U.S. economy.

But elsewhere, in Japan and Europe, indicators point in the opposite direction, with economies recovering slightly. Since the U.S. government must compete with other governments to borrow, central banks that hold off cutting interest rates elsewhere could keep North American rates from falling far.

And even in the U.S., the reports paint a mixed picture. Although job creation has slowed sharply, the unemployment rate has barely budged. That’s because Mr. Trump’s immigration clampdown has pretty much stopped the growth of the labour supply, raising the bargaining power of workers. In the absence of the ICE deportations, some estimates are that the unemployment rate would have risen to nearly 5 per cent by now, which would have resulted in lower wages.

So even if real wages are rising more slowly than they were last year, they’re still heading upwards, reducing the disinflationary impact one would normally get in a slowing economy. Meanwhile, tariffs are starting to show up in the cost of goods. While previously falling prices in the service sector softened this impact, this week’s ISM report revealed this effect to have run its course: Service prices are rising quickly.

The result is that inflation is showing upward pressure. This gives the Fed governors cause for concern that the stable job market could enable workers to demand better wages to compensate, creating an inflationary spiral. They will probably want clear evidence that inflation is coming down, or at least not getting worse, before they proceed to cut.

If for any reason they hold off, that could pose risks for the administration’s other measures to lower borrowing costs. The yield curve control is premised on the assumption that short-term debt, while currently pricey, is worth taking because interest rates will come down in the autumn, enabling the Treasury to refinance cheaply then.

But if the gamble fails, and they’re stuck refinancing at elevated rates, the costs to the government budget could rise. Equally, if interest rates stay high and the market rally stalls, causing holders of stablecoins to cash in some of their investments, it could trigger a sale of bonds that drives down their price, sending interest rates higher.

Tuesday’s inflation report will thus be vital. If it shows inflation trending downward or remaining stable, the Fed may resume cutting rates in the fall. But if the core inflation rate continues rising, as it did last month, the central bank could hold off. Until then, we’re in a nervous wait-and-see mode.