The newly-named Federal Reserve chairman faces an historic challenge that no predecessor has encountered since the years immediately following World War II. In that period, the gigantic spending required to aid our allies and secure military victory saddled the U.S. with towering debt. President Truman—fearing that huge interest costs would swamp the budget—heavily pressured the Fed to hold down rates. Today, the U.S. is wrestling with its biggest budget crisis in 70 years, and we’re confronting a similar conundrum. Gigantic interest payments now devour one in every five dollars we collect in taxes, and the CBO predicts that by 2035, those carrying costs will become the biggest line item of all, exceeding expenditures on Medicare. The already scary math gets far worse if interest rates rise from here, an outcome that would hike what the U.S. pays on every new trillion in borrowings, hence putting deficits on even faster track, and accelerating the spiral in interest expense.
President Trump recognizes the problem big time, and in fact, his crusade for pushing the Fed to lower rates is only secondarily about boosting growth. His prime rationale: Taming the interest dragon that threatens to undermine America’s position as he world’s safest place to invest. In a Truth Social post following the Fed’s decision to leave its benchmark rate unchanged on January 29, the POTUS declared, “The U.S. should be paying LOWER INTEREST RATES THAN ANY COUNTRY IN THE WORLD!…[Jerome Powell] is costing America Hundreds of Billions of Dollars a year in totally unnecessary and uncalled for INTEREST EXPENSE!”
“The interest costs on the debt will be the big tussle between the Fed and the administration,” John Cochrane, a noted economist at Stanford’s Hoover Institution, told Fortune. “If you’re the fire department, and someone else pours gasoline on the fire [meaning via a fiscal policy of huge deficits] you’ll have hard time putting it out.” He notes that if the central bank settles on raising rates to combat our currently-sticky inflation running well over its 2% target—or even leave the benchmark where it sits now—this administration will push back hard. “This is the position any administration would take,” he adds, “and it’s the issue we faced after World War II. Going forward under Warsh or any chairman, it will be very hard for the Fed to raise rates, or even leave them at current levels.”
Here’s the conundrum. If the Fed lowers rates as Trump demands, the budget picture will improve in the short-run. That’s because the central bank holds sway over the yields on T-bills, instruments that mature in a year or less, and U.S. short-term maturities in general. The Treasury is already relying super-heavily on T-bills to refinance maturing bonds and raise fresh cash to fund the immense shortfalls between revenues and expenses that hit $1.78 trillion in FY 2025. In the last fiscal year, T-bills accounted for a staggering 84% of all federal borrowings. And in the next twelve months, no less than $10 trillion in U.S. bonds will come due, and if the Treasury’s practice continues as expected, get replaced by these super-short term securities what will also. in all likelihood. largely fund a FY 2026 deficit at last year’s mark or bigger.
By depressing yields on the T-bills and other shorter-dated Treasuries, and making them a bigger part of all issuance, the U.S. can significantly slow the rise in interest expense versus where it would be if the nation were refinancing maturing bonds and funding the deficits mainly using 5, 10 year and even longer maturities, the reigning practice in the past. But the go-short approach courts big risks. It’s a lot like taking out the kind of “teaser rate” mortgages that eventually skewered homeowners during the 2007 housing meltdown.
Why? Because cutting rates when inflation’s still high could ignite more inflation, meaning the U.S. will need to refinance those cheap borrowings at much higher cost. A fast-rising CPI lifts yields on the 10-year and other longer-term bonds the Fed doesn’t control, but the market does. The Treasury can’t bet on short-term rates forever. It will eventually need to choose safety, lock in costs and extend the maturity profile of the U.S. debt. When that happens, the interest picture could get even worse than if the Fed hadn’t lowered its benchmark rate in the first place—via its failure to make the tough choice that combating inflation comes first.
In the second scenario, Warsh proves a dogged inflation fighter, and takes the position that it’s not the Fed’s job to worry about the fiscal picture. Setting spending and expenses is the responsibility of the president and Congress. The upshot would be high rates even on relatively short-term Treasuries, at today’s numbers or above, for a long time to come. And all the forecasts, including the CBO’s, conclude that such an outcome leads to unsustainable debts, deficits, and especially ballooning interest expense leaving less and less money to fund our fast growing obligations for the likes of Social Security, Medicare and Medicaid.
“Then, the dollar keeps weakening and foreign investors lose confidence is America’s fiscal future,” says Steve Hanke, a distinguished professor at Johns Hopkins University. “This nation loses its ‘exorbitant privilege’ of being able to borrow from abroad at reasonable rates to finance our deficits.” Result: Those foreign investors demand much higher rates to compensate for the rising uncertainty of holding Treasuries, as well as our corporate bonds and real estate. The ramping interest expense that seeded the problem finally morphs into explosion in carrying costs, resulting in a full-blown crisis.
In the longer run, where all this heads isn’t so different if Warsh takes the other tack and follows the Trump formula by slashing the Fed Funds rate—because that would boost 10-year yields, and eventually balloon interest expense as the Treasury give up on hiding the our fiscal plight by borrowing ultra-short.
Few are talking about the debt and deficits as the biggest problem Kevin Warsh has on his hands. But the President gets it. In his Truth Social post where he lashed out at Powell, Trump spotlighted the issue. Unfortunately, his “cutting’s the ticket” solution is only a temporary fix. For Warsh, the best long-term solution is battling inflation at all costs, as part of the Fed’s mandate. But you can be sure it would make him, like Powell, a prime target for the wrath of the president who just anointed him.
