Why an aggressive rate cut could backfire on Trump

NPR

This is the indicator from Planet Money.

I'm Patty Hirsch.

And I'm Adrienne Ma.

It's an exciting week for the indicator because we find out tomorrow how much the Federal Reserve will cut interest rates.

And while it looks like there will be a cut, it's not clear just how deep that cut will be.

Now, the smart money, the analysts and Wall Street types, they're predicting maybe a quarter of a percentage point cut, or maybe a half a percentage point.

Well, who knows?

But however deep the Fed goes, it probably won't be deep enough for President Trump.

On his social media platform, Truth Social a couple of months ago, Trump wrote, Fed should cut rates by three points.

Very low inflation.

One trillion dollars a year would be saved.

Were there any exclamation points there?

Oh, yes.

Three.

Three exclamation exclamation points for, I guess, a requested three percentage point reduction.

Or maybe if you want to be fancy about it, call it 300 basis points.

Ooh, we're fancy.

And, you know, a cut of that size would take the Fed funds rate from 4.5%

today to just 1.5%.

That would be a massive cut.

Massive indeed.

So on today's show, we'll look at what might happen if the president got his way and the Fed did indeed cut rates by 3 percentage points.

What would that do to inflation?

To mortgage rates?

Would it save a trillion dollars a year, as Mr.

Trump claims?

We'll explore it all after the break.

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The Federal Reserve, traditionally, is not an incautious animal.

It is not your 3,000-pound rhinoceros thundering across the savannah.

No, it's more like your 20,000-pound elephant tiptoeing through the trees.

I like the image of a tiptoeing elephant.

Yeah, they have this thing where they hollow out their feet.

They're really super stealthy when they want to be.

Okay, so the point being that the Fed can move fast and aggressively when it wants, but normally with interest rate movements, they only make those in very small and incremental ways.

A quarter point here, maybe a half point there.

So very gingerly making these interest rate moves.

Gingerly, yeah.

So while President Trump leads the Republican Party, and the party symbol is indeed an elephant, his call for a three-percentage point cut to the base interest rate, well, that's more rhino than Dumbo.

He's focused on the rates that people pay for home mortgages.

Michael Strain is an economist at the American Enterprise Institute.

That's a think tank that leans to the right.

He's focused on the rates that businesses pay for longer-term projects.

He's focused on car loans, you know, things of that nature.

Loans of that nature tend to be longer-term deals, like a 30-year mortgage or a seven-year corporate loan or an eight-year car loan.

Trump wants to bring interest rates on these kinds of loans down, but there is a problem.

I think the president is fundamentally confused about how those longer-term interest rates work.

As all loyal indicator listeners know, the Fed effectively sets the base rate, the rate at which banks borrow from each other overnight.

Michael says that overnight rate has a big impact on short-term interest rates, like a six-month bond or a one- or two-year bond.

But when you're talking about 30-year mortgage interest rates, when you're talking about rates on securities of that duration, those are really determined by market forces.

Market forces, as in supply and demand.

Kamal Shri Kumar is president of Sri Kumar Global Strategies.

He advises institutions on investment risks in different countries around the world.

Shri says a deep rate cut would have a big effect on the demand side of the equation.

It is going to put an enormous amount of cash into consumer wallets.

Yeah, it would indeed make it way cheaper to borrow short term, but cheaper money means easier money, means more money, means...

That means inflation will go up even as the federal funds rate, six-month treasury bill, and two-year treasury yields all come down.

Inflation.

as we know it makes money that's been borrowed worth a lot less when it's eventually paid back so lenders need to find ways to compensate for that erosion in value over the long term and also plan for the risk of even higher inflation down the road so how do they do this by charging higher rates on longer-term loans like car loans and corporate loans they all start getting more expensive and the more expensive the loans become the fewer people that are qualified for them the same calculation goes for mortgage breaks etc well.

And that means that the mortgage rate goes up.

Given your level of income, your employment status, your debt history, you do not qualify for a mortgage at a higher rate.

So mortgages are hit, demand for housing is hit, and then you end up with a much lower rate of growth than otherwise.

All right.

So a deep cut in interest rates would likely end up being bad for individuals and businesses.

Higher inflation and rising interest rates on consumer and corporate loans.

But what about the government?

Could a three-point cut save the government a trillion dollars a year, like Mr.

Trump says?

Trump appears to be talking about the amount of interest we pay on U.S.

government debt.

This year, it'll stack up to about $952 billion.

And the president's thinking that a big cut in the Fed funds rate will bring down the rate on longer-term government debt, stuff like the 10-year Treasury note.

Yeah, but just like with consumer loans, the interest rates on long-term treasuries are driven primarily by the market, not by the Fed.

If the Fed does the President's bidding and slashes the base rate, the big funds that buy a lot of this Treasury debt are likely to predict an increase in inflation, and they'll react accordingly.

If today you have an interest rate of, say, 4.3% on the 10-year,

they don't want to lend Uncle Sam for the next 10 years for 4.3%.

They think they'll be losers.

So they're going to demand a higher yield on it, which means that 10-year, 30-year yields increase, and the U.S.

Treasury's debt servicing expenses actually shoot up once that happens.

In other words, a deep, steep rate cut by the Fed wouldn't do what Trump thinks it would.

Instead, it would probably do the opposite.

Inflation would almost certainly rise.

Long-term interest rates would probably increase.

Government borrowing costs would likely grow.

And Mike Strain with the American Enterprise Institute says, if the cut came because the president ordered it, that could do real long-term damage beyond the considerable fiscal and economic costs.

Investors would

perceive holding government, U.S.

government debt to be riskier than they had previously perceived it to be.

They would see an erosion in the norms and institutions here in the United States.

Michael says those institutions, like the Federal Reserve, are a foundation of American prosperity underpinned by their independence from the president and and from politics.

And that independence looks increasingly threatened as Trump works to stack these institutions with loyalists like Stephen Myron, who's confirmed as a Fed governor this week.

And if the Fed were to cut interest rates by 300 basis points, that would be

a pretty big crack.

in the foundation of prosperity.

And that would make

the whole house on which that foundation rests less stable and less secure.

Both Michael and Shree agree that Mr.

Trump's desire to bring long-term interest rates down is a good one.

High rates on consumer and corporate loans and mortgages are a threat to growth and to the biggest engines of the economy.

And high rates on government debt raise the government's operating costs and add to that debt load.

But they say using the Fed to drive these rates down is most definitely not the way to go.

Shree says at least some of Trump's people seem to understand that.

Scott Besson, having been a very successful hedge fund manager in his past, is bright enough, intelligent enough, and he did say, what we are planning to do is to cut the 10-year yield.

We are not trying to work on the federal funds rate, which is the only thing the Fed controls.

Well, the Treasury Secretary is on record saying he thinks the Fed funds rate should be a lot lower.

That is true, but he's not talking about a massive one-time cut.

He's talking about starting with a 50 basis point reduction, which is more tiptoeing elephant than charging rhino.

So he seems to get it.

Hopefully he can explain that to his boss.

This episode was produced by Corey Bridges with engineering by Robert Rodriguez.

It was fact-checked by Sierra Juarez, edited by Julia Ritchie.

Kate Kinnon is our editor and the indicators of production of NPR.

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