In the view of Nir Kaissar, head of the asset management company Unison Advisors, U.S. President Trump may have ultimately found a way to force the Federal Reserve to lower interest rates: fiscal tightening.

It is no secret that Trump wants to lower interest rates. He also seeks more influence over monetary policy, although he has the authority to nominate the Federal Reserve Chair and two Vice Chairs, subject to Senate confirmation. It would be a mistake for the Federal Reserve to grant more independence to this president or any future president, so it is reasonable to doubt that it will do so.

But Caesar believes Trump may have a 'backdoor' to force the Federal Reserve to cut rates. The Federal Reserve's monetary policy has attracted widespread attention and often criticism. Less noticed is the impact of fiscal policy, which in recent years has been at least as influential as the Fed's historic actions.

Since the Federal Reserve began combating inflation, there has been a significant divergence between U.S. fiscal and monetary policy. The Federal Reserve has attempted to slow economic growth by raising short-term interest rates, which increased by more than 5 percentage points in just over a year starting in 2022, marking the largest rate hike in 50 years, before slightly retreating last autumn. Since the rate hikes began, the Federal Reserve has also reduced its balance sheet by over $2 trillion, about a quarter of its original size.

Fiscal policy, on the other hand, has taken the opposite path. Since the spring of 2022, Congress has injected a large amount of fiscal stimulus into the economy in the form of a cumulative $4.2 trillion deficit, accounting for about 6% of GDP during the same period. In comparison, the average annual deficit as a percentage of GDP since World War II is 2.6%. This includes the massive deficits incurred by Congress during the 2008 financial crisis and during the pandemic to support the collapsing economy—Caesar believes these measures were correct, as they helped the U.S. avoid a recession in recent years.

U.S. fiscal policy and monetary policy have been in opposition.

Today, fiscal and monetary policies may soon swap roles. Treasury Secretary Scott Bessent has stated that the government aims to reduce the deficit to 3% of GDP. This would require Trump's Department of Efficiency (DOGE) to cut $1 trillion in spending. It is still unclear how much of this goal can be achieved, but the mere threat of spending cuts may already be suppressing market sentiment and hindering economic development.

Relevant signs are accumulating. Consumer confidence fell for the first time in six months in January. The Bloomberg US Financial Conditions Index has dropped 37% in the past two weeks, indicating that economic activity is slowing. The Atlanta Fed has cut its estimate for the first quarter's annualized real GDP growth rate by nearly half, from nearly 4% a month ago to 2.3%. During this time, the yield on the 10-year U.S. Treasury bond fell by 50 basis points to 4.3%, quickly approaching the yield on the 2-year U.S. Treasury bond, a trend that many economists view as a harbinger of an impending recession.

An economic slowdown, especially one accompanied by a weakening labor market, could likely prompt the Federal Reserve to cut interest rates. Otherwise, it is hard to imagine the Fed loosening policy under other circumstances. The Fed's preferred inflation measure—core personal consumption expenditures (PCE) rose 2.8% year-on-year in December, still above its 2% target, which is concerning. Therefore, as long as the economy continues to grow and the unemployment rate remains at historic lows, the Federal Reserve can delay interest rate cuts until inflation is under control.

However, through spending cuts, Trump could force monetary policy to loosen to support fiscal tightening. Whether Trump's spending cuts lead to an economic slowdown is irrelevant. As long as these cuts (or threats of cuts) occur simultaneously with an economic slowdown, the Federal Reserve may take action.

However, there are several ways this situation could be disrupted. Trump's tariffs could trigger inflation while cutting spending and slowing the economy, leading to stagflation, which would compel the Federal Reserve to raise rates even in the face of an economic slowdown. On the other hand, more optimistically, as the government hopes, cuts in spending could create room for more private sector investment, which could continue to boost the economy and the labor market, giving the Federal Reserve more time to address inflation.

Whatever happens, it is clear that, with the cooperation of Congress, the White House is pursuing a new fiscal path. The Federal Reserve will have to contend with the fact that Trump has already exerted some influence over monetary policy, whether it likes this intervention or not.

Article reposted from: Jinshi Data