by William C. Dudley, Chair, Bretton Woods Committee; Former President, Federal Reserve Bank of New York
The Trump administration is focused on getting interest rates down, and with good reason. A 1% reduction in the level of interest rates would reduce the federal government’s debt service costs by about $3.5 trillion over the next decade—comparable in size to the cost of the One, Big Beautiful Bill Act.
Are US interest rates abnormally high?
It depends on what timeframe one uses. Relative to 2009 to 2022 levels, interest rates are high. But that period is not representative of the current environment. During that period, short-term interest rates were unusually low because inflation was generally below the Fed’s 2% inflation target, and the Fed was trying to push it back up. Longer-dated yields were also pushed down by the Fed’s quantitative easing programs. In contrast, current short- and long-term yields are below the average of the 1970-2009 period.
So what levers are the Trump administration using?
There are a number of initiatives. First, President Trump has made it clear that Fed Chair Jerome Powell should sharply lower short-term interest rates. Second, Treasury Secretary Scott Bessent wants to push longer-term Treasury rates down by limiting the supply of long-dated issuance and shifting borrowing into shorter-term maturities. Third, the banking regulators have proposed lowering the supplemental leverage ratio (SLR) capital requirement for banks. This requirement requires banks to set aside the same amount of capital for Treasuries as for more risky assets. If the SLR is less binding, banks would have an incentive to hold more Treasuries.
What will be the impact of these initiatives?
With respect to the pressure on the Fed, the effort could be counterproductive over the near-term. With inflation somewhat above the Fed’s 2% objective and uncertainties about the effects of tariffs on employment and inflation, the Fed wants to be patient and see how the economy performs before cutting interest rates further. President Trump’s pressure could also make Fed officials more reluctant to cut short-term rates because that might be viewed as succumbing to political pressure. If investors thought the Fed was not independent, this could push up inflation expectations, forcing the Fed to keep short-term interest rates higher for longer.
Capping the supply of longer-term Treasuries could put downward pressure on longer-dated yields. But the main drivers of long-term yields are future expectations of short-term rates and the sustainability of the country’s fiscal position which could limit the impact of a supply cap.
The Treasury has generally avoided short-term tactical adjustments to the composition of its Treasury issuance in favor of being regular and predictable because this strategy has been viewed as the best way to minimize the Treasury’s funding costs over time.
Reducing the SLR should encourage banks to hold more Treasuries, but the impact on longer-term yields is questionable because banks have limited appetite for increasing their interest rate risk exposure.
What are the headwinds to pushing down Treasury yields?
There are three major obstacles. First, the US fiscal trajectory is on an unsustainable course. Despite spending cuts by Congress, the One, Big Beautiful Bill’s tax cuts may exacerbate the challenge by decreasing government revenue. The budget deficit is projected by the Congressional Budget Office (CBO) to average more than 6% of GDP over the next decade, more than double the 3% target of the Treasury Secretary that would likely be sufficient to stabilize the level of federal debt relative to GDP. Stronger growth than CBO’s forecast will be required to meet the 3% target.
Second, the Trump administration’s trade and tariff policies appear to have reduced the appetite of foreign investors to hold Treasury securities. This is evident in the fact that the value of the dollar has declined significantly; the opposite of what typically happens when a country raises its tariffs on its trading partners.
Third, inflation remains above the Fed’s 2 percent target. Because this is the fifth year in a row that the Fed has missed its inflation target to the upside, inflation expectations remain at risk of becoming unanchored. This has pushed up the bond term premium—the difference between bond yields and the expected path of short-term rates.
How else can the administration lower interest rates?
There a number of ways to push yields lower.
- Maintain Fed independence. Doing so would help keep inflation expectations well anchored.
- Take steps to improve attractiveness of U.S. Treasuries. This includes measures to make the Treasury market less vulnerable to stress, such as moving more aggressively to central clearing requirements for all Treasury trading. Encouraging the Fed to open its standing repo facility to all Treasury investors, rather than just limiting access to banks and primary dealers, would also increase the attractiveness of Treasury securities relative to other assets. Increasing the Treasury’s buyback program of less liquid Treasuries would also make the market more efficient.
- Take steps to restore the confidence of foreign investors in the United States. This could include making it clear that the Trump administration does not favor an accord that would require foreign governments to swap their Treasury holding for low-yielding, long term maturities. Reducing uncertainty about trade policy by striking agreements with America’s largest trading partners that lower tariffs and reduce non-tariff barriers to trade would increase the willingness of foreign investors to increase their Treasury holdings. Currently, foreign investors hold about 30% of all Treasury securities outstanding.
- Begin serious discussion about how to put the country’s fiscal house in order. One important area that requires attention is the Social Security trust fund for retirement and survivors’ benefits, which is projected to be exhausted in 2033. If bond investors were confident that the US fiscal path was sustainable, this would push bond yields lower and reduce debt service costs.
While there are multiple strategies to lower interest rates and reduce debt service costs, meaningful movement will ultimately depend on maintaining Fed independence, restoring foreign investor confidence, and addressing the underlying fiscal sustainability challenges that are keeping Treasury yields elevated.
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William C. Dudley, Chair, Bretton Woods Committee; Former President, Federal Reserve Bank of New York