Krugman: Is the U.S. debt so crazy because the market believes Trump will go crazy?

The Federal Reserve enters a rate-cutting cycle, yet U.S. Treasury yields soar. What is the market pricing in?

On January 8, Paul Krugman, a Nobel Prize-winning economist from the United States, published an article stating that although the Federal Reserve has begun to cut interest rates, long-term rates (such as 5-year auto loans, 10-year corporate bonds, and 15 or 30-year mortgage rates) have risen, contrary to the direction of short-term rates (such as the federal funds rate). This phenomenon is unprecedented.

Krugman suggested that the rise in long-term rates, such as the 10-year U.S. Treasury yield, may reflect a terrifying, quietly spreading suspicion that Trump actually believes the crazy things he says about economic policy and may put them into practice.

Krugman indicated that the bond market's reaction shows that investors have begun to foresee the inflationary pressures these policies could bring, thus altering expectations for future Federal Reserve policy:

If he actually implements any significant part of these policies, the Federal Reserve will obviously have to pause further rate cuts. In fact, the Federal Reserve may feel it necessary to raise rates again.

However, given that Trump may demand the Federal Reserve continue to cut rates, Krugman believes that if the Federal Reserve ultimately yields to this pressure, it would mean rates would rise further, not fall:

Many economics students know that Richard Nixon forced the Federal Reserve to keep rates low before the 1972 election, despite the increasingly severe inflation problem. Ultimately, this led to soaring inflation and interest rates.

If bond investors are starting to worry about Trump's 2.0 madness, why is the stock market rising?

Krugman offered two possible explanations:

The first is that stock investors and bond investors are not the same; the former are more emotional and more easily influenced by sentimental factors. Everyone knows about meme stocks, which surge due to social media frenzy. As for meme bonds, I haven't heard of them.

The second explanation is that the recent rise in the stock market is actually quite narrow. It can be said that this is mainly due to the impact of artificial intelligence. The Dow Jones Industrial Average can be seen as a representative of the non-AI economy, which has almost erased the gains from the Trump effect.

Here is the full text of the article:

After the inflation surge in 2021-2022, the Federal Reserve responded by significantly raising interest rates. Even by the end of 2023, when inflation was close to the Federal Reserve's (arbitrary) 2% target, the Federal Reserve still maintained high rates for a long time. However, the Federal Reserve finally began to cut rates last September. So, do you feel a bit of relief?

Probably not. The Federal Reserve only controls short-term rates—specifically, its target is the federal funds rate, which is the overnight lending rate between banks. However, the rates that truly affect people's lives are long-term rates: such as 5-year auto loans, 10-year corporate bonds, or 15 or 30-year mortgages. And an interesting thing has happened: these long-term rates have actually risen. Since the Federal Reserve began to cut rates, the benchmark 10-year U.S. Treasury yield has risen by an amount roughly equal to the decline in the federal funds rate

This divergence is unprecedented. As Thorsten Slok of Apollo Global Management pointed out in a report on Tuesday, typically when the Federal Reserve cuts interest rates, long-term rates at least decline somewhat:

Therefore, what we are seeing now is very unusual. Slok said:

The market is telling us something, and for investors, it is crucial to understand why long-term rates are rising when the Federal Reserve is cutting rates.

So, I think there are three main explanations here:

The market is the market, naturally.

It is difficult to squeeze out that last bit of inflation.

The bond market is starting to doubt whether Trump truly believes the crazy things he says about economic policy and will put them into practice.

I intend to defend the third viewpoint, although I am also aware that this may just be overly optimistic thinking.

The difference between short-term and long-term rates, and even their movements in opposite directions, is not contradictory. Investors choosing between short-term and long-term investments are essentially always betting on future rates. For example, by the end of 2024, the average interest rate for a 1-year fixed deposit is 1.76%, while for a 3-year fixed deposit, it is 1.43%. Does this mean the 1-year fixed deposit is more attractive? If you expect future rates to decline, you should lock in that 1.43% rate as soon as possible.

So, if long-term rates are rising while the Federal Reserve is cutting rates, it may be because investors are raising their expectations for future Federal Reserve rates. So why would they do that?

You should not assume that the market is always right, especially not think that the market knows things that the rest of us do not. John Maynard Keynes once made profound and elegant points about the "fragility" of market pricing, arguing that the market often overlooks long-term factors. Although most of his discourse applies more to the stock market than the bond market, as the bond market tends to be more sober. But bond investors are also betting on future macroeconomic trends, and the information they have is no different from that of any economist who knows how to use FRED (Federal Reserve Economic Data).

Nevertheless, I still hear a lot of discussions about how cooling inflation is much easier than many economists predicted—we should not forget those who claimed that controlling inflation would require a 6% unemployment rate for five years—but now there are views that inflation may stagnate between 2.5% and 3%, rather than falling back to 2%. Is this statement accurate?

Well, I have spent quite a bit of time reading economists trying to parse the data and estimate potential inflation rates; is it 2.8%? 2.4%? Or 2.1%? I have done some of that work myself. But now I feel like we are like some soothsayers looking for omens in the entrails of sacrificed goats However, it is worth mentioning that businesses, especially those closer to the market than ordinary people, do not seem to believe that inflation will cool down in the short term:

This leads to the third point: the rise in long-term interest rates, such as the 10-year Treasury yield, may reflect a terrifying, quietly spreading suspicion that Donald Trump actually believes the crazy things he says about economic policy and may put them into practice.

Look at the dynamics of recent days. Jeff Stein of The Washington Post reported that people around Trump plan to introduce a series of relatively limited strategic tariffs, rather than the destructive trade war he has consistently promised against all countries; Trump quickly responded by posting that this report is "fake news" and claimed that he indeed intends to impose high tariffs on every country and all goods.

In short, the source says: "Trump is not as crazy as he seems." Trump: "Yes, I am!"

Then, to eliminate any doubts that he might be more rational than he appears, Trump held a press conference where he seemed to propose annexing Canada, possibly invading Greenland, seizing the Panama Canal, and renaming the Gulf of Mexico to "American Gulf." This morning, CNN reported that Trump is considering declaring a national economic emergency— in a country with low unemployment and low inflation!— as an excuse to significantly raise tariffs.

What does this have to do with interest rates? Economists almost unanimously agree that the high tariffs, tax cuts, and large-scale deportation of illegal immigrants announced by Trump will exert significant inflationary pressure, although this effect may not be immediately apparent; whatever Trump does, inflation may remain low for much of this year. However, if he actually implements any significant part of these policies, the Federal Reserve will clearly have to pause further rate cuts. In fact, the Fed may feel it necessary to raise rates again.

Indeed, Trump—who just claimed yesterday that interest rates are still too high—would certainly be furious if the Fed raised rates. In fact, he might demand that the Fed continue to cut rates. And considering that almost all major U.S. institutions are flattering themselves, can we really be sure—really, really sure—that the Fed can maintain its independence? Can we imagine Fed officials hiding in their offices when MAGA supporters storm the Eccles Building? In fact, we can imagine that.

But if the Fed ultimately succumbs to this pressure, it would mean that interest rates will rise further, rather than fall. Many economics students know that Richard Nixon forced the Fed to keep interest rates low before the 1972 election, despite the increasingly severe inflation problem. Ultimately, this led to a surge in inflation and interest rates.

But you might ask, if bond investors start to worry about Trump's 2.0 madness, why is the stock market rising? I can offer two possible explanations. The first is that stock investors and bond investors are not the same; the former are more emotional and more easily influenced by sentimental factors. Everyone knows about meme stocks, which have surged due to the frenzy on social media. As for meme bonds, I haven't heard of them.

The second explanation is that the recent rise in the stock market is actually quite narrow. It can be said that this is mainly due to the influence of artificial intelligence. The Dow Jones Industrial Average can be seen as a representative of the non-AI economy, which has almost erased the gains from the Trump effect: Well, I don't want to push this issue too far, partly because I don't want to fall into the trap of motivational reasoning. Those of us who are fearful of Trump's rise certainly hope he will be punished in the market, but we should not expect to see results immediately. The consequences of Trump's economic delusions may take years to manifest.

But even if the Federal Reserve cuts interest rates, rising interest rates may already be an early signal of future trends