In his appearance before Congress last week, Fed Chairman Jerome Powell once again reiterated the central bank’s cautious stance: it is not rushing to cut interest rates, firstly because the economic situation allows it for now and, secondly, because it is concerned that the ongoing trade war could trigger a spike in inflation.

And indeed, the data is already showing the first signs of the negative impact of higher tariffs. Although the PCE price index rose by only 0.1% month-on-month and 2.3% year-on-year in May, core inflation was slightly higher than expected at 0.2% month-on-month and 2.7% year-on-year, with goods prices leading the way.

So why are investors still pricing a 21% chance of a rate cut in July, which has supported the S&P 500? First, there is still hope for progress in trade negotiations. Second, there is a growing belief that further deterioration in the labor market could finally force the Fed to make the long-awaited move.

Market expectations for interest rates could also be shaped by Trump’s attacks on Powell and reports that he’s considering potential replacements. Trump has argued that the Fed should cut rates to 1%, claiming it would save the U.S. hundreds of billions of dollars in interest on the national debt.

For reference, the U.S. spent $1.1 trillion on debt interest in 2024, nearly double what it paid five years earlier.

The problem is that if the Fed’s independence is undermined, investors could start demanding a higher risk premium, especially for 10-year and 30-year treasuries, thus we could see higher yields. And the damage won’t be limited to just bonds. Trump’s political meddling could also hurt the dollar.

The effect already seems to be affecting the dollar index, which has slipped toward the 97-point mark. Sentiment could be further clouded by an OMFIF survey showing that many central banks plan to increase their exposure to the euro and the yuan, reducing their dependence on the dollar.

That said, it would be far better for the economy if the Fed made its decisions based on economic fundamentals rather than political pressures, which could create more problems than they solve. Ultimately, much will depend on whether real progress is made in the trade talks with key partners.

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