Lower mortgage rates, lower credit card rates, lower business loan rates, you name it. People borrowing money would pay less for it. The economy might boom and the markets soar.
President Trump has left no doubt that if he gets his way, the Federal Reserve will lower the short-term interest rates that it controls directly. Lower rates tend to stimulate the economy and the stock market, developments that are, not incidentally, good for incumbent presidents and their political parties.
But the effects of lowering rates beyond a level that is appropriate for the economy are complicated, and not entirely positive. In fact, while they might well benefit Mr. Trump and the Republican Party, they could lead to higher inflation and, ultimately, even higher interest rates. What’s more, any action that impairs the Fed’s credibility could make the institution less capable of responding effectively in a serious financial crisis.
In a telephone conversation, Tim Duy, chief U.S. economist for SGH Macro Advisors, a financial research firm, laid out some of the less obvious implications of the current battle between Mr. Trump and the leaders of the Fed, notably, Jerome H. Powell, whose term as chair expires in May.
The next Fed chair “would have to resist the pressure from Trump and do the right thing” on setting policy, Mr. Duy said. If the Fed acquiesces to Mr. Trump’s demands for a sharp rate cut, even if economic conditions don’t warrant one, Mr. Duy said, the economy might get a “sugar high” in time to help Republican chances for the 2028 election, but there could be long-term damage to the economy. “There’s a reason the independence of the Federal Reserve is an important issue,” he said.
The Struggle
That battle for the future of the Fed moved to the Supreme Court on Wednesday. Justices heard arguments on the validity of Mr. Trump’s attempt to fire Lisa Cook, a Fed governor since 2022, based on an allegation that she engaged in mortgage fraud, which she denies. In an apparent gesture of support for Ms. Cook and opposition to Mr. Trump’s efforts to control the Fed, Mr. Powell attended the court session, a rare appearance for a Fed chair.
The Justice Department issued subpoenas this month as part of a criminal investigation into Mr. Powell. In a video-recorded statement, he said the investigation was merely a contrived “consequence of the Federal Reserve setting interest rates based on our best assessment of what will serve the public, rather than following the preferences of the president.”
As I’ve pointed out, the Fed has fought for its independence before. Mr. Powell could follow the example of Marriner S. Eccles, who lost his job as Fed chair but stayed on as Fed governor and helped to lead a fight with the Truman administration. Mr. Powell’s term as governor continues until January 2028.
It’s not clear how the latest fight will play out. But let’s consider what might happen if Mr. Powell and his allies lose, and Mr. Trump gains control of the Fed.
The Economic Risks
We know that the president wants rates to fall, sharply and immediately. Lower rates would reduce the cost of financing the national debt. Mr. Trump told The Wall Street Journal in December that within a year, interest rates should be “1 percent and maybe lower than that.” The federal funds rate, the Fed’s benchmark policy rate, now stands between 3.5 and 3.75 percent. There’s a big gap between 1 percent and the current rate.
Arguably, the federal funds rate could be lower than it is now. Economics is a science, but an evolving one, and setting interest rates is something of an art form. Nonetheless, few economists believe current conditions support a big rate decline. And most economists would say that, given the relatively high inflation rate, low unemployment rate and robust growth of the economy, rates are relatively close to where they ought to be.
No matter. If short-term rates fell sharply, there’s an excellent chance that the stock market would rally, in my estimation. After all, the markets have generally jumped in response to Fed rate cuts because lower rates imply that money will be cheap and easy to borrow, leading to more purchases by consumers and greater profits for businesses.
But over longer periods, excessively low rates are likely to spur inflation, most economists say. In the sense that lower interest rates imply that more money will be flooding into the economy, the adage of Milton Friedman, the monetarist and Nobel laureate, is relevant. “Inflation is always and everywhere a monetary phenomenon,” he wrote in 1970, adding that “it is and can be produced only by a more rapid increase in the quantity of money than in output.”
When the economy is already running near full capacity, adding stimulus through lower rates is likely to increase inflation. And in the bond market, which the Fed doesn’t directly control, longer-term rates might increase in anticipation of an environment of rising prices.
In a note to clients, Mr. Duy illustrated some of these issues by using a standard economic model. He examined the effects of a systemic “policy error” in which the Fed lowered interest rates by just one percentage point more than was justified by a widely used measure of monetary policy, the Taylor Rule. (Mr. Trump’s demand that rates fall at least 2.5 percentage points would amount to a far greater policy error.) Devised by John B. Taylor, a Stanford economist, the Taylor Rule incorporates inflation and economic or labor market activity, and suggests an appropriate interest rate.
The rule is widely known. Though it has limitations, it can be used as a benchmark against which Fed policy can be judged.
In fact, the Federal Reserve Bank of Atlanta publishes an online “Taylor Rule Utility” that you can try yourself, adjusting inputs like your inflation target and estimate for economic growth. It shows that by most measures, Fed policy right now is fairly close to what mainstream economics would suggest.
A Case for Independence
Veering sharply downward from an appropriate interest rate would probably affect the economy in stages, Mr. Duy told me. “The impact on inflation might not show up for 10 to 12 quarters,” or up to three years, he said. “The impact on output happens first. You get the economic boost, unemployment falls. And it takes some time before that works its way into higher inflation.”
It’s probably too late to create an artificial economic boom in time for the midterm elections in November, but it might be possible to do so for the 2028 presidential election, Mr. Duy said. It would lead to a bad economic hangover, but that would be a problem for the next president.
Then there are broader repercussions. I’d expect a loss in public confidence in the Fed. And if the institution were no longer functioning independently, it could lose some of its capacity for quick, deft responses to emergencies. This could be devastating when the Fed is needed to stabilize the economy.
A political Fed might not be able to safeguard the value of the dollar, which is the linchpin for the entire global financial system. Investors around the world would be less likely to keep their money in U.S. assets. That would weaken the U.S. economy and hurt people in the United States who benefit from the dollar’s special status.
U.S. consumers would have to live in an environment in which higher inflation — and periodic efforts to tame it — become the norm. Numerous academic studies have shown that independent central banks are more effective at reining in inflation than banks that act as agents of governments.
As Daniel Altman, an economist and former colleague at The New York Times, who is the author of the High Yield Economics newsletter, put it recently, “living standards would drop” if the Fed were no longer in control of monetary policy. “Your wallet,” he added, “is in for a rough ride if the Federal Reserve loses its independence.”
Jeff Sommer writes Strategies, a weekly column on markets, finance and the economy.
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