Filenews 8 July 2025 - by Bill Dudley
U.S. leaders have clung to the idea that they can tackle some big problems — most notably the huge budget deficit — by pushing interest rates lower.
I wish it was that easy.
President Donald Trump continues to increase pressure on the U.S. Federal Reserve to cut short-term interest rates, publicly expressing his dissatisfaction with President Jerome Powell.
At the same time, Treasury Secretary Scott Bessent wants to lower longer-term interest rates by issuing less long-term debt. Financial regulators are modifying capital requirements, encouraging the largest U.S. banks to buy and hold more Treasury bonds, which will push prices up and yields down.
If these efforts worked as intended, they could yield significant benefits. If interest rates were just one percentage point lower than the current Congressional Budget Office's projections, the government could save about $3.5 trillion in debt servicing costs over 10 years — more or less what the "Big, Beautiful Bill" just passed by Congress is expected to add to the federal budget deficit over the same period.
Unfortunately, the government's efforts are almost unlikely to succeed – and could even have the opposite effect.
Let's talk about the Federal Reserve. Trump's attacks, along with his stated goal of installing a president who will advocate lower interest rates, threaten to raise expectations for future inflation and therefore lead to a rise in long-term bond yields. Any suspicion that the Fed could back down on the president's demands would only make things worse. Therefore, to compensate for the Trump factor and maintain market confidence, the Fed will likely have to turn to a more cautious approach, keeping short-term interest rates higher than it would otherwise have.
Bessent's plan to issue government bonds may have some results. If the same number of investors bid on a smaller supply of long-term government bonds, yields will have to fall. But the movement will be marginal at best, in basis points, not percentage points. Long-term yields depend much more on the expected path of short-term interest rates than on the composition of government bond issuance. Also, by moving away from a decades-old policy of "regular and predictable" issuance, the Treasury Department's move could create uncertainty that will undermine any benefit.
Worse still, the Treasury has to borrow enough to finance the huge budget deficit. Thus, it will have to issue more short-term securities, making the government's finances more sensitive to future changes in short-term interest rates. In the extreme scenario, if all government debt were short-term, the cost of servicing government debt would skyrocket every time the Fed raised interest rates. This could lead to fiscal dominance, in which the government's fiscal hardship would severely damage the Fed's ability to manage the economy.
Easing capital requirements is not much better. This is a complementary leverage ratio, which limits banks' ability to hold government securities because it treats all assets equally, regardless of risk. It is a measure designed to be a "backstop" to ensure that banks have enough equity to absorb losses to survive an economic downturn or financial crisis. Easing will not be enough to lead to a big drop in longer-term yields. Banks' appetite for these government bonds will be limited because they do not want excessive exposure to interest rate risk.
If government officials really want to cut interest rates, they have better options — including rejecting policies that push in the wrong direction.
First, bring the government's finances under control. The Big, Beautiful Bill is a fiscal disaster: It is likely to add more than $3 trillion to the federal deficit over a decade, causing more government bond issuance and ever-higher debt servicing costs. Some elements of prudence – for example, reforming social security to put it on a more sustainable trajectory – would reassure investors.
Secondly, greater clarity and certainty with regard to trade policy. Trump's tariff wars have reduced foreign investors' appetite for U.S. bonds. Look, for example, at the sharp fall of the dollar, even though higher tariffs should lead to a stronger currency.
Third, stop threatening the Fed's independence. The preference for lower interest rates should not be the main qualification for the next Fed chairman.
Fourth, abandon any thought of a "Mar-a-Lago Agreement," which would force foreign governments to swap their government portfolios for long-term, low-yield liabilities.
Fifth, to make the bond market more resilient. For example, centrally clearing more transactions would make it less vulnerable to glitches such as the "dash for cash" seen in March 2020. Opening up the Fed's financial facility to all Treasury securities holders, not just banks and key dealers, would encourage a wider range of investors to own more securities. The same would happen with the expansion of the Treasury Department's debt buyback program, which is designed to increase liquidity in non-market securities.
The Trump administration probably won't follow most of this advice. But the math is indisputable: On the current trajectory, a decade from now, the cost of servicing deficit debt, Social Security and health care will each be one percentage point of GDP higher, according to the Congressional Budget Office. Pressure to cut interest rates will not be an essential part of the solution.
