Fed chair nominee Kevin Warsh. — Reuters
UNITED STATES President Donald Trump has been on a crusade to get the Federal Reserve (Fed) to lower its policy rate, but his focus now seems to be shifting to long-term borrowing costs.
Fed chair nominee Kevin Warsh will struggle to deliver on that front.
This is bad news for the millions of borrowers facing high mortgage rates and, of course, Trump himself, whose fate in November’s mid-term elections could hinge on the “affordability crisis” facing voters across the country.
Treasury secretary Scott Bessent has spoken of wanting a 10-year yield with a 3% “handle,” something seen only fleetingly during Trump’s second term in office.
The White House has blamed this on current Fed chair Jerome Powell’s unwillingness to lower rates aggressively, but that’s a pretty specious argument.
In truth, the Fed only really has control over the short-term Fed funds rate.
This is the base for longer-term business, credit card, auto, and mortgage loans, but the interest rate on these loans is primarily determined by the benchmark 10-year Treasury yield, over which the Fed has little control.
For example, Powell’s Fed reduced the policy rate by 75 basis points late last year.
Yet the 10-year yield drifted higher and is now around 4.30%.
This has “steepened” the yield curve, or widened the gap between short-and long-dated yields.
In theory, a steeper curve reflects a healthy, more “normal” economy. But today’s curve – the steepest in four years and still rising – may also signal that the longer-term inflation and rate outlook is darkening.
This disconnect reflects US bonds’ rising “term premium” – the extra yield investors demand for holding long-term Treasuries rather than short-term debt.
Rising premium
That premium on 10-year Treasuries is near its highest level in over a decade.
Why is it rising? Largely because US inflation and consumer expectations of future inflation are uncomfortably elevated, and the trajectory for public finances remains worrisome.
Concerns about central bank independence haven’t helped.
Interest rate futures markets expect a Warsh-led Fed to lower the fed funds rate by 50 basis points this year, but there is little indication that long-term rates will follow suit.
Does that mean investors are flagging a potential policy mistake, whereby further rate cuts at this point will ultimately lead to higher inflation – and higher rates – down the line?
Possibly, but, regardless, they seem unconvinced that Warsh, or any Fed chair, will be able to push rates down across the curve.
Warsh, like Bessent, thinks otherwise. He argues that the key to cutting the policy rate, lowering inflation expectations, and ultimately getting longer-term borrowing costs down is an artificial intelligence (AI)-driven productivity boom.
Even Powell recently signalled this could help the central bank meet its inflation target.
If this scenario plays out, mortgage rates could drop, giving a shot in the arm to the housing market and boosting the “wealth effect.”
Thirty-year mortgage rates have not dipped below 6% since the summer of 2022. Trump, a former real estate tycoon, is as aware of this as anyone – and keen to do something about it.
Banking on an AI bailout is a gamble, however.
Not only is the productivity-enhancing quality of AI yet to be proven, but it’s also a stretch to assume that it will offset all the other forces putting upward pressure on inflation and long-term yields.
Risky position
Washington’s medium-to long-term fiscal health remains precarious.
Wall Street is booming. Financial conditions are the loosest in four years, according to Goldman Sachs.
Real growth is running at around 4%, based on the Atlanta Fed’s GDPNow model estimate, implying nominal growth of around 7%.
None of that suggests long-dated yields are about to decline much, or that the Fed funds rate should keep falling.
A clear deterioration in economic data, a labour market swoon, or a geopolitical shock could flip the outlook, but that’s probably not in the Bessent-Warsh playbook.
This may be why Trump, with one eye on the November mid-terms, has sought to target long-term rates directly, threatening to cap credit card interest rates at 10% and announcing that the government will buy more mortgage-backed securities.
But that doesn’t mean he will refrain from pushing the new Fed Chair to help with the cause.
The problem, of course, is that he can’t do much. — Reuters
Jamie McGeever is a columnist for Reuters. The views expressed here are the writer’s own.
