Are interest rates too high?
Is President Trump right?
President Trump recently posted to social media that the Federal Reserve is keeping interest rates too high. The federal funds rate, charged on overnight loans between banks, is currently 4.5%. In contrast, Switzerland’s central bank is only charging 0.25%. That’s easy money! Is the Federal Reserve stifling American economic growth, and forcing us to pay unnecessary interest on the national debt?
To answer that question, I looked at historical data, from 1954 Q3 to 2025 Q1. The Federal Reserve has two missions: to control inflation, and to promote economic growth. I used statistical methods to forecast the federal funds rate as a function of 1) the year over year percentage increase in the Consumer Price Index (CPI), and 2) the year over year growth of gross domestic product (GDP).
It turns out that the inflation rate is a strong predictor of the federal funds rate, and GDP growth is a good predictor. Putting them together in one model gives me predictive power (R-squared) of 53%, which is fairly good.
How much does the actual federal funds rate differ from what my model forecasts? The graph below provides the answer.
The model does a good job of forecasting the true federal funds rate (errors close to zero) most of the time, with two glaring exceptions. In the first Reagan administration in the early 1980s, rates were outlandishly high, perhaps unnecessarily so, some 5-8 percent higher than they needed to be. During the Biden administration in the early 2020s, rates were even more extravagantly low, definitely unnecessarily so, some 6-9 percent lower than they needed to be.
One possible hypothesis about the outliers is that the Fed is being political, punishing Reagan and rewarding Biden. If the model is correct, the target for the federal funds rate right now should be about 3.6%, lower than the current 4.5% but much higher than Trump’s suggestion of 0.25%.
One must also consider the impact of the huge federal debt. As a proportion of GDP, America’s federal debt is 121%, 8th largest in the world. In order to encourage investors to buy government debt when the existing debt already exceeds GDP, you must offer investors attractive interest rates. The Fed could lower interest rates to 0.25%, and then no one will buy Treasury notes, which are positively correlated with the federal funds rate. Then the United States goes bankrupt within months.
Federal spending absolutely must be brought under control, decreased, and finally forced to be less than revenue, so we can start paying off our crippling debt. Then watch interest rates come down.
Why is there a need for the Fed to set interest rates? If the US is a truly capitalist country, what would happen if interest rates were determined simply by supply and demand? Wouldn't this cause interest rates to be exactly where they needed to be? The problem with the Fed is that react to economic conditions either too slow or quickly, and often to an extreme. This causes widely swinging markets, recessions and inflation. The money supply and the velocity of money then react unnaturally. This negatively effects the (middle class) consumer, hence the economy.