Giving the world economy a dose of bleach

Trump and how not to treat the rise in interest ratesRecently I have been writing about financial matters and the risks associated with rising interest rates in the US. For sure, the phenomenon is not limited to the United States. Japan raised interest rates, in an effort to support the yen, bringing them to their highest level since 1995. The European Central Bank recently raised its deposit rate to 2.5 per cent amid continuing concerns about inflation. The US dollar’s situation, however, is much more significant because its effects are eventually felt throughout the world. In early September, President Trump felt the need to express his views on rising interest rates as well. Following the latest data on US job creation, he wrote the following on Truth Social. These are verbatim extracts: “Great jobs number just announced, breaking all estimates (except mine!) by double and triple – And you haven’t seen anything yet! EMPLOYERS ADDED 162,000 JOB IN AUGUST. Lower the interest rates because the U.S.A. is a much stronger credit than it was just a short time ago! A STRONG COUNTRY MEANS A LOWER INTEREST RATE – IT’S A BETTER CREDIT…Very simple! We should have the LOWEST RATE of any country in the World, like ‘the old days.’ […] LOWER THE RATE OR I’LL STOP TRADING WITH COUNTRIES WITH WHICH WE HAVE A DEFICIT […] The Fed Board, with its great new leader, must get smart – BE PATRIOTS for a change. High interest rates put the U.S.A. at a very unfair disadvantage, and I won’t allow that to happen!” In a way, the above reminded me of the way President Trump sought, during his first term, to address another thorny problem: Covid-19. At a televised press briefing in April 2020, Trump speculated about whether disinfectant could be injected into the human body to kill the virus. The suggestion was immediately rejected by medical experts as dangerous. It appears that President Trump’s rather unconventional approach to treating viruses extends into other areas, even though, arguably, financial matters are closer to his expertise. Threatening to stop trading with countries running trade surpluses with the United States unless the Federal Reserve lowers interest rates, makes no more sense than using disinfectant to treat Covid. More importantly, it reveals a fundamental misunderstanding of how interest rates are determined. Since I started writing on this subject, downward pressure has been building on the price of US Treasury securities across the maturity spectrum. Since bond prices and yields move in opposite directions, this means that yields have been rising. Τhe influential 10-year Treasury bond yield passed the 5 per cent mark, and reached its highest level since 2007. Treasury Secretary Scott Bessent, eager to support the president’s objectives, has tried various methods of encouraging lower yields. So far, the markets have proved difficult to persuade. There are several explanations for the rise in interest rates. The glass-half-empty view, as The Economist recently put it, is that uncontrolled government deficits are encouraging expectations of higher inflation, requiring investors to demand higher interest rates as compensation. The optimistic view – and, not surprisingly, the one favoured by the administration – is that the rise in rates has little to do with inflation expectations. Rather, it is a reflection of a strong economy that will eventually generate higher growth and, in time, help reduce the burden of government debt. Then there is another explanation: traditional buyers of US securities, including the world’s central banks, have been diversifying away from the dollar and into gold. Geopolitical uncertainty makes holding US dollar assets less attractive than it once was. As with most things in economics, there is an element of truth in all three explanations. In actual fact more than one reason can be true at the same time. On September 16, the Fed in a unanimous decision under chairman Kevin Warsh, raised its fed funds rate by 0.25 per cent going directly against the president’s wishes. This after the release that annual consumer price inflation remained stuck at 3.4 per cent in August, unchanged from its July level. Coupled with the strong jobs performance the president bragged about above, indicating that the economy was running too hot, there was little the Fed could do if it was not to lose credibility. This was a clear signal that inflation is indeed a concern and that the Fed’s action signified its intention to step up its efforts to bring it down. The enormous investment associated with the expansion of artificial intelligence is behind the optimistic scenario. This is generating strong demand for borrowing and jobs, which itself has put upward pressure on interest rates. But the economic growth expected from AI remains uncertain and is unlikely to materialise immediately. Even some tech bosses are now acknowledging the need to proceed more cautiously to ensure that adequate safeguards are in place. Not surprisingly, the greatest president of all time has rejected calls for an AI slowdown and tighter regulation of the industry. He appears far less concerned about growing fears that the technology could pose an existential threat than about ensuring that the United States does not lose the AI race to China. And then there is geopolitics. The war involving Iran is dragging on, while the Houthis in Yemen continue to threaten oil supplies and shipping routes. An Omani initiative to bring Iran and the Gulf states together to discuss navigation through the Strait of Hormuz on September 14, was postponed. Still, this shows the increasing lack of confidence by the Gulf states (significant holders of US Treasuries) in the US resolving the mess Trump’s war has created. The stance of Saudi Arabia is particularly interesting. Its recently signed defence agreement with Pakistan (a nuclear power no less), alongside Turkey, is unlikely to be irrelevant to the changing strategic environment. Nor is the reported refusal by Trump to provide direct US military assistance when Saudi Arabia came under attack from the Houthis. None of this means that Saudi Arabia or the other Gulf states are about to dump their US Treasury holdings – as things stand now, they are faced with significant unrealised losses. But it does suggest that the assumption that the US dollar will always be the unquestioned safe haven is no longer quite as secure as it once was. All of the above makes bringing interest rates down in the near future a tricky endeavour. And while identifying the reasons for rising yields is important in designing a strategy to reduce them, there is an immediate issue that concerns me even more. The fact that interest rates are already high, and could remain so, increases the likelihood of a financial crisis in the United States – something I wrote about a few weeks ago. And this is where the president’s simplistic argument about the United States being a “stronger credit” becomes particularly revealing. In a response to the Fed increasing rates he wrote: “Interest Rates in the United States should be 1%, or less, because we are the Best Credit in the World — BY FAR.” But a country’s creditworthiness does not mean that its central bank should automatically set the lowest interest rate in the world. Switzerland (a country that attracts Trump’s ire for being “elite”) has a benchmark policy interest rate of 0 per cent by virtue of inflation being at 0.2 per cent. Interest rates are not a prize awarded to the country that considers itself the strongest. They are a price – the price of money – determined by inflation, economic conditions, fiscal policy, expectations and, ultimately, the willingness of investors to hold it. If the market believes that inflation, government borrowing or geopolitical risk has increased, it will demand a higher return. No presidential declaration can repeal that arithmetic. The medical experts fighting Covid in 2020 wisely ignored the president’s advice on disinfectant. The financial experts at the Federal Reserve have similarly ignored his advice on interest rates. It appears that the emperor is increasingly being seen without clothes. What that means for the remainder of his presidency, particularly after the important November midterm elections, is difficult to predict. A wounded animal is often said to be at its most dangerous. Better prepare by stocking up on some anti-bleach medication.