- US economy’s price, activity, and fiscal data still point to upward higher inflation.
- A Fed serious about targeting inflation toward 2% ought to be reticent about cutting rates.
- The markets’ disapproval of Fed policy could show up in higher bond yields.
- This in turn could cause President Trump to forcefully cap long-term rates.
- Then the USD would come under pressure, reducing US assets’ attractiveness to foreigners.
Commentary: The post Fed-capitulation phase
Regardless of the outcome of Donald Trump’s attempts to oust Federal Reserve Board governor Lisa Cook, it is clear that between political pressure and signs of a weakening labour market, the FOMC is heading toward cutting the policy rate. The near-term communication may be one of data-dependence and the transitory nature of pipeline tariff-induced inflation, with the end outcome being a series of rate cuts in the next 12 months. It may happen mostly under Chair Powell’s tenure before it ends in May 2026, but that’s not relevant any longer, in our view. The bottom line is that short-term US rates will be much lower a year from now.
But what if this path is challenged by the markets? Since the Fed’s impending shift toward cutting rates follows relentless attacks on the Fed by the US President, questions about the US central bank’s independence and policy credibility are reasonable. The markets’ way of not buying the Fed’s rate move was illustrated last year, when the Sept-2024 surprise 50bps rate cut was followed by a 70bps rise in US 10-year bond yields in the next two months. The market’s reaction was clear; the data on prices, wages, jobs, economic activity, and fiscal did not warrant such a move.
Similar concerns galore at this moment. Economic activity is strong, with the Atlanta Fed Nowcast tracking 2-3% GDP growth. On the labour market front, job creation has softened a tad, but unemployment (4.2%) is low and wage growth is solid (3.9%). Meanwhile, inflation is showing up in areas beyond tariff and goods. Services costs picked up in July, with the personal consumption expenditure-based inflation data release showing upward momentum in recreation, housing, and financial services prices. The fiscal situation, despite all the headlines about spending cuts, is not getting any better, with the Federal Spending Tracker showing government expenditures up 7.4%yoy through end-August.
Given all this, a Fed serious about targeting inflation toward 2% ought to be reticent about cutting rates, but it is guiding markets toward that very scenario. Just like it was the case in late 2024, the market’s reaction has been to worry about inflation down with the road, with tempering the demand for long-term bonds. The yield curve has begun to steepen, which does not bode well for financial market outlook.
But the markets’ reluctance to absorb long-term bonds could antagonise Trump, who can unleash a series of measures. He can insist on the Fed to resume bond purchases and pursue yield curve control. He can penalise countries through tariffs if they sell treasuries. He can even impose outright interest rate caps. The casualty from all this would likely be a considerably weaker dollar. Foreign holders of US assets beware.
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