Conflict of interest

Trump invents a completely fictitious reasons for charging Powell (Source: here) 

The Trump Administration has launched an all-out assault on the independence of the central bank of the United States, the Federal Reserve. Here is why Trump's attack matters greatly not just to Americans, but also to the rest of the world.

Over the weekend, it emerged that the US Department of Justice (DOJ) has served grand jury subpoenas on Federal Reserve Chairman Jerome Powell. DOJ is pushing criminal charges related to a congressional testimony Powell gave in June of 2025 about ongoing renovations of the Fed's headquarters (see here).

In reality, DOJ's charges against Powell have nothing to do with the renovations at the Fed; the real target is Jerome Powell himself. Trump appointed Powell in his first term, but now he wants to get rid of him in order to replace him with a lackey, who will do Trump's bidding, no questions asked. The fact that DOJ is leading the charge should surprise no one; for some time now DOJ has been one of Trump's main political attack dogs.

Trump's problem with Powell is that he turned out to be both skilful and full of integrity; Powell has repeatedly refused to carry out Trump's orders that the Fed cut rates. Powell said in a statement on Sunday that Trump wants US interest rates to be set based on political pressure and intimidation rather than on economic conditions and evidence.

Trump does not care about long-term economic stability, he cares about his popularity. Trump has noticed that the economy is not performing terribly well and that he is falling behind in the polls ahead of November's midterm election. He wants Powell to cut rates to boost his poll ratings. Powell is refusing, because economic conditions, including inflation do not warrant rate cuts at the speed and in the magnitude demanded by Trump.

In a sign that he is getting desperate, this week Trump also called for the imposition of a one-year 10% cap on credit card interest rates. This is the kind of policy heterodoxy we normally only see in populist backwaters. Unsurprisingly, US bank stocks reacted negatively to the announcement (see here).

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Why worry about Trump's interference at the Fed? In the United States, the Federal Reserve has a high degree of institutional independence. In exchange for the power to set interest rates, the Fed has to balance growth and price stability in such a way as to optimise the performance of the US economy over the business cycle. Fed independence is motivated by the observation - backed up by plenty of empirical evidence - that the credibility of monetary policy is much enhanced when politicians are not involved in interest rate decisions.

Why should politicians not set interest rates? Basically because political interference in what is a highly technical task leads to awful outcomes. Politicians invariably cut rates in order to enhance their own political popularity, rarely paying attention to overall economic conditions. As a result, politically motivated rate cuts usually usher in inflation, which then has to be brought down at a later stage, which usually takes even higher interest rates and even deeper recessions than would have been the case had there been no political interference to begin with.

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To understand how political interference in rate setting decisions adversely impacts the economy, it is useful to briefly review some basics. The main instrument used by the US Federal Reserve to control the temperature of the American economy is called the Fed Funds rate. When the Fed moves the Fed funds rate, it directly influences short-term interest rates in financial markets as well as in the banking system. From there, longer-term interest rates and the economy as a whole are impacted.

The relationship between short-term and long-term interest rates is determined by riskiness. It is generally riskier to lend money over long periods than over short periods, so longer-term interest rates usually have to be higher than short-term interest rates in order to induce anyone to lend longer term. When you plot interest rates of different durations on a chart (with the rate of interest on the y-axis and the length of the loan on the horizontal axis) you therefore usually get an upwards-sloping curve. Such a curve is called a yield curve - see chart below.

US yield curve (Source: own drawing) 

The Fed funds rate anchors the US yield curve at the very short end. When the Fed raises or lowers the Fed funds rate, the other (longer-term) interest rates in the economy rise or fall as well (see chart below). These other interest rates include the borrowing rates of the government as well as the cost of private sector credit, such as consumer loans, car loans, business credit, student loans, and mortgages.

A Fed hike (Source: own drawing) 

The overall level of interest rates in any given economy reflects the credibility of the country's macroeconomic policies and other structural parameters; countries with very credible economic policies and highly diversified economies tend to be able to borrow at lower interest rates than countries poor records of economic management and less developed economic structures.

The steepness of the yield curve is an indicator of the immediate economic outlook; in countries where the outlook is becoming less predictable you typically see the yield curve steepen, reflecting the increasing riskiness surrounding longer-term lending under greater uncertainty.

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With that pre-amble, let us return to Trump and his attack on Powell. When Trump attacks the independence of the Federal Reserve, he directly undermines the credibility of US macroeconomic policy. If he manages to replace Powell with a toady, we may see a short-term boost to economic growth, but this benefit will soon be exceeded by the cost of rising inflation and greater economic instability.

What Trump is proposing to do at the Fed is the policy-equivalent of pissing in your pants to keep warm; sure, you make an initial splash, but for reasons that quickly become apparent you soon regret your decision.

If Trump goes ahead regardless what should we expect to happen to the US economy and ordinary Americans? Let us assume Trump replaces Powell with proper sycophantic yes-man, who does everything he is told. This seems a reasonable assumption, because why else go through the laborious and politically risky process of getting rid of Powell?

First, the market will instantly conclude that Trump's lackey will cut the Fed funds rate, regardless of what is happening to growth and inflation. The cut will initially bull-steepen the yield curve, meaning short-end rates will fall. However, this is not the end of the story. Since the Fed cut is known to be motivated by politics rather than economic conditions, markets will also price in greater inflation and instability in the future, which pushes up rates at the long end of the yield curve. This is called bear-steepening and it tends to be bad for the most important sector in the US economy, namely housing as mortgage rates price off the long end of the yield curve.

But there is more. The loss of macroeconomic credibility also puts a damper on American companies' willingness to invest for the long-term. US productivity growth therefore slows, and, with it, economic growth. Company earnings then start to suffer, which hurts the US stock market (the stock price being the present value of expected future earnings). The economic slowdown also worsens the US fiscal situation by reducing tax revenues and increasing certain types of statutory counter-cyclical spending, including claims for unemployment benefit.

Bear in mind, the US fiscal outlook is already quite precarious. The US government is running unsustainable fiscal deficits due to Trump's wildly irresponsible 'Big Beautiful Bill', which adds chunks to the government's already eye-watering stock of debt (118% of GDP as of now).

Trump's replacement of Fed chairman Powell will also impact the Dollar. Remember global currency markets are notoriously fickle, with investors constantly shifting huge volumes of cash around the world in search of the highest real rates. If the Fed lowers the Fed funds rate in conditions of high or rising inflation, the real interest rate on bank deposits in the United States falls. Investors then take their money out of US banks, convert it to other currencies, and move it overseas in order to put it into banks that offer higher real rates. The outflows push down the Dollar.

Rising borrowing costs and a declining Dollar materialise could not happen at a worse time. A huge amount of US government debt is presently held by foreign institutional investors, who are highly sensitive to the value of the Dollar. When the Dollar sinks, these investors - which include central banks, sovereign wealth funds, pension funds, and insurance companies as well as retail investors - will lose money on any Dollar-denominated assets they hold on their books. Naturally, they will therefore seek to reduce their exposures. When they sell US government bonds the sales push up borrowing costs for the US government. The government can either accept the higher borrowing costs, which will hurt the US economy and further undermine fiscal sustainability, or it can prevent rates from rising by dramatically cutting spending (or raising taxes), but this also hurts the US economy. In short, there are no easy options due to the high level of debt.

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Unfortunately, Trump's attack on the Fed also hurts the rest of the world, where many countries are far too dependent on the US. A significant proportion of foreign wealth is invested in US assets, notably in US equities. This is because US financial markets are the largest and most liquid in the world and because the Dollar has historically been underpinned by sensible Fed policies. If Fed credibility is now heading for the gutter and long rates go up and growth slows and the Dollar weakens then a lot of overseas wealth will simply be wiped out. In turn, this will hurt growth, consumer spending, and investment.

At the same time, the weaker Dollar will make it harder for the rest of the world to export goods and services to the United States. This is actually a quite serious issue, because exports to the US from the rest of the world are very large. Remember that the US runs a massive trade deficit with the world, because, until now, the world has been willing to finance consumption in the United States far in excess of American production. With a much weaker Dollar, however, American imports will quickly get far more expensive and Americans will buy fewer goods and services from abroad.

Also bear in mind that the Dollar and US government bonds jointly make up important corner-stones of the global financial system. Many regard US government bonds as risk-free. In my view, this is complete nonsense, which reflects serious regulatory failures, but the view is widespread nevertheless. According to the risk-free fiction, government bonds issued by other countries must be riskier than US government bonds, wherefore they should always trade at higher yields than US bonds (a so-called ‘spread' over the corresponding point on the US Treasury yield curve). It follows that if US real yields rise then real yields in other countries must also rise, thereby causing contagion to spread from bad US fiscal policy to financial distress in other countries, even if the public finances in those other countries were fine to begin with.

The uncertainty surrounding the value of the Dollar will also lead to bifurcation in currency markets. Currencies that are perceived to be risky will be dumped, while perceived safe haven currencies will rise on demand for 'safety'. Both sets of currencies actually end up with problems; countries with rising currencies, typically Japan or Switzerland, have their export competitiveness undermined by currency over-valuation and may additionally experience Dutch Disease-style problems (excessive temporary demand stimulus due to capital inflows). Meanwhile, countries with crashing currencies are cut off from international financial markets and could even get pushed into default as a result.

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In conclusion, we should all be concerned about Trump's attack on Powell. It exposes a huge flaw at the heart of the global financial system, namely its excessive reliance on the United States. For far too long, financial markets have assumed US markets, especially US Treasuries, to be risk free. Yet, nothing is further from the truth and we may soon come to see how.

There is really no excuse for still being overweight US markets. They are expensive and, by now, Trump's political modus operandi is well-documented. We know Trump identifies those who depend on the US the most and then threatens them to exploit their dependence. This is how he treated immigrants, American universities, foreign trading partners, fellow members of the NATO alliance, and America's closest neighbours. Now, it seems, he has set his sights on investors at home and abroad, who, unsurprisingly, are poorly prepared. This is the finance industry after all.

The End