The Fed’s complex dilemma: Balancing Trump’s attacks, bond market doubts and the ghosts of 2007

The dismissal — pending an imminent legal battle — of Federal Reserve Governor Lisa Cook has called into question the sacrosanct independence of the U.S. central bank from a White House that is all but obsessed with cutting interest rates.

The impact on the market has been clear, but limited in magnitude: Cook’s future will be decided in the courts, and in any case, it does not alter the balance for the Fed’s upcoming decisions. Still, short-term bonds have fallen on expectations of a looser monetary policy, while long-term bonds have risen on the view that a more permeable Fed implies higher inflation in the long run.

The most immediate focus is the September 16–17 meeting, where Cook’s presence is in limbo: Trump considers her dismissed, she plans to appeal the termination on the grounds that it is without legal basis, and the Federal Reserve will abide by judicial rulings. The turmoil has not significantly altered market expectations: they assign an 87% probability that the Fed will cut interest rates, compared to 84% last Friday. If that happens, the U.S. central bank would break with an unwritten rule of monetary policy: not lowering the cost of money in an environment of rising prices.

According to a Bank of America report, this scenario hasn’t occurred since the second half of 2007, on the eve of the Great Financial Crisis, when the Fed chose to cut rates amid rising global energy and food prices — prioritizing early signs of weakness in housing and labor markets that eventually led to the worst financial crisis in 80 years, fueled by excessive debt and complex financial engineering that concealed real risks.

Fast-forward to 2025: employment data has been disappointing lately, and on that basis, Jerome Powell suggested at Jackson Hole last Friday a policy shift after 10 months without rate cuts. Still, there are no recession prospects on the horizon, while U.S. inflation closed July at 2.7%, the same rate as June but higher than May’s 2.4% and April’s 2.3%. Core inflation, excluding food and energy, fared worse, rising to 3.1% — its highest in six months — above June’s 2.9%. Although the Fed has a dual mandate of price stability (controlling inflation) and maximum employment, since 1973 only 16% of rate cuts have occurred while inflation was rising.

Howard Du, a currency analyst at Bank of America and author of the report, believes the consequences of cutting rates against rising inflation are clear. “This is a possible but historically rare regime. Fed rate cuts amid rising year-over-year inflation suppress the real policy rate in the U.S. and lead to a weaker dollar,” he writes under the grim title Ghosts of 2007.

And a potential shift in the Fed’s balance of power only reinforces this trend. A report by ING argues: “President Trump’s firing of Fed Governor Lisa Cook and the broad view that this marks further politicization of the Fed are negative for the dollar.”

The impact on the bond market also causes an unintended side effect: it mitigates the impact of rate cuts. Unlike in Spain, where mortgages are tied to Euribor, in the U.S. the benchmark for trillions in outstanding fixed-rate mortgages is the 10-year Treasury. It is considered the risk-free asset with a duration close to the average life of loans (though issued for 30 years, they are paid off earlier due to repayments or home sales). Mortgage spreads are calculated against this benchmark.

In other words, if the bond market anticipates higher inflation and the 10-year yield rises, rate cuts don’t translate into lower mortgage costs, nor into cheaper business loans. This is especially the case when two other forces push bond yields upward: tariffs, which are also inflationary, and the U.S. fiscal deficit.

“The combination of weaker U.S. payroll growth and the White House baiting of the Fed, both institutional and personal, is starting to create real issues for investors in US Treasuries,” David Roberts, head of fixed income at Nedgroup, told Bloomberg. In fact, over the past 12 months, despite the Fed cutting rates by 100 basis points, long-term yields have risen by 60, largely due to inflation expectations.

“When the Fed cut interest rates in September 2024, it did so against a backdrop of falling inflation, with year-over-year headline CPI falling from 3.5% to 2.4% in the previous six months,” adds Howard Du, who also notes that the dollar’s sell-off — it’s down 12% against the euro so far this year — has its strongest correlation with 2007 since 1973.

The parallels don’t end there. “Concerns about the Federal Reserve’s independence have not been seen for 50 years, when Nixon pressured Arthur Burns to keep interest rates low in the early 1970s, with serious consequences,” another Bank of America report states. That period is known in the U.S. as The Great Inflation, and “not becoming another Arthur Burns” has become something of a mantra among central bankers. “

“Although the market seems increasingly comfortable with political risk (especially after Trump’s intervention in April), there is no doubt that the risks are real, something the market has been pricing in despite the apparent complacency reflected in the headlines,” the report states.

The Bank of England’s mistake?

Other central banks face a dilemma similar to Powell’s. In this cycle of interest-rate cuts, the Bank of England has been slightly more aggressive than the Fed, lowering rates from 5.25% to 4% since August — while the Fed has cut one point, from 5.25–5.50% to 4.25–4.50%. But it has run into surprisingly negative inflation in July: 3.8%, two-tenths higher than the previous month and the highest since January 2024. That unexpected increase has led analysts to view another cut by the Bank of England before the end of 2025 as increasingly unlikely.

Powell, nearing the end of his term and having consistently charted his own course against Trump’s pressures, will try to avoid making the same mistake. With little to lose — just eight months remain in his mandate, and he knows he will be replaced — his decisions will likely aim more at securing a favorable judgment from history than at pleasing a president who has attacked him by land, sea, and air.

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