Senior central bank reporter warns: Trump pressures the Federal Reserve to cut interest rates to cover the fiscal deficit, consequences could be very serious

U.S. President Donald Trump is pressuring the Federal Reserve to cut interest rates to reduce the cost of deficit financing. This "fiscal dominance" strategy currently has the support of investors, driving the stock market to new highs. However, veteran central bank journalists warn that such practices are typically associated with weak central banks in emerging markets and may lead to inflation, crises, and economic stagnation.

On July 5, Greg Ip, a senior central bank journalist at The Wall Street Journal, published an analysis article stating that Trump's recent intense demands for Federal Reserve Chairman Jerome Powell to lower interest rates or step aside for someone willing to do so. Unlike before, this time the demand for rate cuts serves his fiscal goals — to provide financing support for the recently passed tax cut legislation by Congress.

The article indicates that Trump is attempting to break the traditional link between budget deficits and interest rates. Traditional economic theory holds that large-scale borrowing raises interest rates, thereby offsetting the benefits of tax cuts. However, Trump's strategy is to pressure the Federal Reserve to force lower interest rates to align with his fiscal policy objectives.

This "fiscal dominance" model has historically been associated with weak central banks in emerging markets like Argentina, often resulting in a combination of inflation, crises, and economic stagnation. However, in the short term, this model may serve as a powerful economic stimulus, which also explains why the stock market continues to reach new highs under this expectation.

The Real Purpose Behind Trump's Pressure on the Federal Reserve to Cut Rates

Trump has long claimed to be a "low-interest-rate person," but Ip points out that his latest demands add a crucial new dimension—he wants to achieve his fiscal priority goals through lower interest rates.

To avoid the risk that traditional bond issuance might push up long-term rates, Trump's Treasury Department is trying a new approach. Ip reveals in the article that the Treasury has signaled that bond issuance will favor short-term securities and Treasury bills. The aim is to avoid the impact of rising long-term rates on government financing costs.

However, this strategy carries risks. If short-term rates spike, costs will quickly impact the budget. Trump clearly does not intend to let this happen. As he stated on Fox News: "We will let those who can lower rates into the Federal Reserve."

Historical Lessons of "Fiscal Dominance"

What is fiscal dominance? Ip explains that the phenomenon of "fiscal dominance" occurs when the central bank shifts its focus from employment and inflation to government financing. This situation is typically associated with emerging markets that have weak central banks, such as Argentina. The result is usually some combination of inflation, crises, and economic stagnation.

However, Ip also notes that reaching that critical point may take years. Meanwhile, fiscal dominance may serve as a strong stimulus factor. Although fiscal dominance is not yet the status quo in the U.S., the mere possibility of it may already be influencing the market.

Historically, central banks and government finances have been intertwined for a long time. The Bank of England was established in 1694 to help the monarchy raise funds.

The Federal Reserve assisted government financing during World War I and World War II, and in the 1960s, it avoided tightening policies to accommodate Treasury bond issuance, which fueled inflation Since then, the Federal Reserve has avoided explicit coordination with fiscal policy. Ip stated that the zero interest rate and bond-buying policies from 2008 to 2014 were based on the Federal Reserve's independent judgment of the inflation situation, rather than presidential directives, and therefore do not constitute fiscal dominance.

Bond Market's Response and Concerns

Ip provided some key data in the article to illustrate the current fiscal situation. According to the Committee for a Responsible Federal Budget, the initial proposal from House Republicans would increase the deficit from last year's $1.8 trillion (6.4% of GDP) to $2.9 trillion by 2034 (6.8% of GDP).

Even more concerning is that the bill passed on Thursday is even more extravagant: the deficit will rise to $3 trillion over ten years, accounting for 7.1% of GDP. If the temporary tax cuts in the bill are extended, similar to the tax cuts of 2017, the deficit will climb to $3.3 trillion, or 7.9%.

However, even in the face of such a massive deficit, the U.S. has never run such a large deficit for such an extended period, yet the yield on the 10-year Treasury bond has fallen from 4.55% in May to 4.35% on Thursday.

Goldman Sachs economists recently concluded that Powell's successor will not be as concerned about the deficit issue as Powell, and therefore will likely lower interest rates further in the coming years. This expectation seems to be influencing market pricing.

However, Trump's current threats to the Federal Reserve have not changed investors' expectations for future inflation. Perhaps they believe that regardless of what Trump wants, the Federal Reserve will remain true to its mission. Even if they do not believe this, the cost of fighting the Federal Reserve is quite high.