Under the pressure of fiscal deficits and tariff conflicts, the independence of the Federal Reserve is facing the most direct structural test.

Written by: Zhang Yaqi, Wall Street Journal

The confrontation between the Federal Reserve and Trump is entering the most direct standoff phase.

For the first time in three years, the Federal Reserve raised interest rates, increasing the federal funds rate by 25 basis points to a range of 3.75% to 4%. Trump immediately demanded that interest rates be reduced to 1% or even lower, accusing the Federal Reserve of "acting against him for political purposes." Federal Reserve Chairman Waller clearly responded at a press conference: inflation has exceeded its target for more than five consecutive years, this interest rate hike decision aligns with the Federal Reserve's dual mandate, and it was unanimously approved by the committee.

The essence of this standoff is the structural tension between an economy that remains fundamentally strong and a government that continuously overreaches in fiscal, tariff, and geopolitical policies. The Federal Reserve has chosen to stand firm, while Trump's proposal for a 1% interest rate lacks both justification and feasibility in the current macro environment.

First interest rate hike in three years, Waller cited "excessive inflation" as the reason

The Federal Reserve announced a 25 basis point interest rate hike last week, marking its first increase in three years. Waller provided two core arguments at the subsequent press conference: First, inflation has consistently run above the target for over five years, and price stability is the current policy's top priority; second, the U.S. economy is currently showing signs of strengthening, making it necessary to moderately remove accommodative stances in this context.

This decision not only marks a change in policy direction but also directly responds to market signals. On September 17, the yield on 10-year Treasury Inflation-Protected Securities (TIPS) was about 2.6%, while the traditional 10-year Treasury yield was about 4.9%, implying an inflation compensation of about 2.3%. From a historical perspective, both nominal yields and real yields have broadly reverted to levels seen before the 2007 to 2009 financial crisis, and combined with recent economic performance, the current yield levels are within a reasonable range.

It is worth noting that Waller refused to support or endorse Trump's drastic interest rate cut demands at any level—whether in terms of policy stance or rhetorical language. The interest rate hike decision was ultimately passed unanimously by the committee, demonstrating high internal unity within the institution.

Trump's 1% proposal: the logic does not hold

Trump stated on social media that the U.S. is "the most creditworthy country in the world," and that interest rates "should be 1% or even lower," accusing the Federal Reserve of raising rates purely as "a political action against Trump." He also revealed that he had informed Waller, "It would be better to vote with the committee because the outcome will not be any different."

However, the logic of short-term policy interest rates is not directly related to a country's credit rating. Short-term rates are driven by macro variables such as inflation and unemployment rates, not by the country's credit rating. Long-term nominal rates are determined by real rates, expected inflation, and various risk premiums. In the current context where inflation remains above target and fiscal deficits are high, pushing policy rates down to 1% would imply real rates of about negative 2%, a level likely to provoke creditor protests or even a lending strike.

Additionally, the assertion that "the U.S. has the world's best credit" itself deserves scrutiny. The term "credit" comes from the Latin word "credere," meaning "to believe." The U.S. has the largest and most dynamic economy in the world, but its government's credibility is under pressure due to the Trump administration's ongoing breaches of rules in fiscal and tariff policies. Analysts point out that given the massive fiscal deficit, the high dependence on external financing, and the trend of bondholdings shifting from long-term holders to hedge funds, a financing crisis is not unimaginable.

Long-term excessive inflation and policy multiplier: multiple pressures converged

From a broader perspective, since 2021, both overall inflation and core inflation indicators have persistently run above target. At the same time, the demand expansion brought about by the wave of artificial intelligence investments, the Trump administration's loose fiscal stance, the supply-side shocks of increased tariffs, and the energy price shocks triggered by the war in Iraq have all converged, making the prospect of inflation naturally falling more uncertain, with upward pressure instead.

In this context, some observers have raised substantial questions about Waller's monetary policy framework. Noted economist Claudia Sahm posed several key questions in her Substack column: What mechanisms does monetary policy use to promote growth? If a tighter monetary policy does not suppress economic activity, what other pathways can lower inflation? Does Waller have a clear judgment of "neutral interest rates"? If not, how can the current looseness of policy be assessed? These unanswered questions are critical observation points for watching Waller's Federal Reserve.

However, Waller maintains a cautious attitude toward economic predictability, which to some extent creates a methodological divergence with some concerns from critics, rather than a complete departure.

Testing central bank independence: the final test has yet to come

The current standoff reflects a deeper structural proposition: how a fundamentally strong economy can respond to a government that continually overreaches in fiscal and policy matters. The responsibility of the Federal Reserve is to maintain the credibility of its inflation target without interference from political pressures; however, the pressure from the Trump administration is putting this responsibility under public scrutiny.

Waller's current position is to maintain the normal monetary policy framework without yielding to political pressures. The unanimously approved interest rate hike decision carries significant institutional signaling. But as analysts point out, the real test of this game may not have arrived yet—in a scenario where fiscal pressures and inflation pressures rise together, whether the Federal Reserve can continue to stand firm will be the core variable determining the final direction of this confrontation.