【MACRO Insight】Policy Game between Trump and the Federal Reserve: The Interweaving of Interest Rates

Recently, U.S. economic policymakers are facing a series of complex challenges, including high real interest rates, volatile inflation expectations, and fiscal policy uncertainty. These factors not only affect the Federal Reserve's monetary policy decisions, but also have a profound impact on market and investor confidence.

It‘s no secret that President Trump is unhappy with the Federal Reserve’s decision not to cut interest rates. Less noticed, however, is that Sen. Elizabeth Warren, D-Mass., the top minority member of the Senate Finance Committee, has taken the same stance. At a recent committee hearing, Warren urged Fed Chairman Jerome Powell to “move quickly to lower interest rates, with meaningful rate cuts starting next month.” The call reflects the direct political influence on economic policy and reveals the tensions in the current economic situation.

And new research shows the importance of short-term interest rates adjusted for inflation and taxes. Based on this adjusted short-term rate, the current one-year Treasury yield is more than a percentage point higher than the average level of the past two decades. This finding reveals a key issue: when comparing interest rates, it is necessary not only to adjust for inflation, but also to consider the impact of taxes. Because the bond market already takes tax factors into account when setting yields, it should also be adjusted accordingly when comparing current interest rates with historical interest rates.

Estimates of future inflation are a key factor in calculating interest rates adjusted for inflation and taxes. One reason that interest rates are above average at this time is that inflation could rise faster in the coming months than currently expected. If this forecast comes true, then interest rates will prove to be not significantly above average.

The Cleveland Fed's inflation expectations model , which incorporates several important factors, including inflation swaps and break-even inflation rates, estimates that inflation over the next 12 months is 2.73%, well below the 4.27% yield on the one-year Treasury. Therefore, to bet that inflation over the next 12 months is above 2.73% is actually to bet that you know better than the collective wisdom of the trillions of dollars invested in the inflation swap and Treasury markets.

Trump's initial policy proposals have raised concerns about rising inflation at the Fed. According to the minutes of the recently released January policy meeting, participants "generally noted upside risks to the inflation outlook" rather than risks to the job market. In particular, participants mentioned the potential impact of possible changes in trade and immigration policies, the possibility that geopolitical developments could disrupt supply chains, and stronger-than-expected household spending.

Although he still believes that price pressures will ease in the coming months, Atlanta Fed President Bostic detailed a series of problems the Fed is trying to solve in an interview with Yahoo Finance. Business leaders told Fed officials that they want to raise prices but are unsure how consumers will react; tariffs may increase costs, but deregulation measures on certain industries may offset these pressures. This phenomenon shows that Trump's trade policy may have a direct impact on inflation.

Financial markets reacted relatively muted to the minutes, with interest rate futures suggesting the Fed's first and only rate cut, likely through 2025, will come in July. U.S. stocks swung between small gains and losses. Policymakers agreed they should keep interest rates unchanged until it is clear that inflation, which has been largely stagnant since mid-2024, can reliably fall to the Fed's 2% target. Uncertainty about Trump's plans has fueled their hesitation to cut rates further.

In another sign of how fiscal policy might affect Fed decisions, the minutes said “multiple” policymakers noted that it might be necessary to consider slowing or pausing the Feds ongoing balance sheet reduction given the federal “debt ceiling dynamic.” Current federal funding is set to run out after March 14, and lawmakers need to act before the summer to raise their self-imposed debt ceiling or risk default.

Most importantly, they also made it clear that they would not change their commitment to the 2% inflation target or to achieving maximum employment. The current economic situation is full of uncertainty, from Trump's trade policy to the Federal Reserve's monetary policy to potential changes in fiscal policy, these factors together shape the future direction of the US economy. Investors and policymakers need to pay close attention to these dynamics in order to make wise decisions in a complex and changing economic environment.