From interest rate games to fiscal kidnapping, can the Federal Reserve maintain its independence?

Byron Gilliam, Blockworks

Compiled and edited by BitpushNews

There was a time when Federal Reserve chairmen had the freedom to lecture politicians about their irresponsible spending habits. It was a pleasant era.

For example, in 1990, Alan Greenspan told Congress that he would lower interest rates, but only if Congress reduced the deficit.

In 1985, Paul Volcker even put a number on it, telling Congress that the Fed's "stable" monetary policy depended on Congress cutting about $50 billion from the federal budget deficit. (Ah, that's $50 billion in federal debt, not even in the days of rounding errors.)

In both cases, Fed chairmen implicitly threatened Congress and the White House with recessionary risks: You have a great economy right now; it would be a shame if something went wrong.

Now, however, the situation is reversed, with US President Trump "lecturing" the Fed about interest rates.

In recent weeks, Trump has declared the federal funds rate "at least 3 percentage points too high," insisted there's "no inflation," and mocked Fed Chairman Jerome Powell as "Too Late Powell."

That's also a form of pressure: You have good central bank independence...

Trump also lobbied for lower interest rates during his first term. Like nearly every modern American president, he wanted the Fed to stimulate the economy.

This time, however, it's much more than that: Trump wants the Fed to finance the deficit.

The Trump-Powell showdown is ostensibly about the current level of interest rates (the Federal Open Market Committee (FOMC) left rates unchanged today, which likely displeased the president).

But what the president has been threatening is "fiscal dominance"—a state in which monetary policy is subordinated to government spending needs.

"Our interest rates should be three percentage points lower than they are now, saving the country $1 trillion a year," the president recently wrote on Truth Social in his signature casual capitalization.

By repeatedly making such statements, Mr. Trump has made history as the first American president to explicitly call for fiscal dominance.

But he is by no means the first to acknowledge such a possibility.

When Volcker and Greenspan threatened Congress with rate hikes, they brought to the fore the usually hidden connection between monetary and fiscal policy.

It worked for them: Both Fed chairmen successfully used the threat of recession to get Congress to address deficit spending, a promising precedent.

But that strategy seems unlikely to work this time.

Chair Powell has frequently warned of the risks of growing deficits, even explaining that higher deficits could mean higher long-term interest rates.

But it's hard to imagine him making the explicit threats that Volcker and Greenspan did—perhaps because he knows he's in a significantly weaker bargaining position.

In the 1980s, the most feared consequence of raising interest rates was a recession, a risk the Fed was willing to take to get Congress to change its profligate spending habits.

Back then, lawmakers faced a ballooning defense budget and a stagnant economy, both of which seemed manageable.

Federal debt, at just 35% of GDP, seems manageable.

Now, federal debt is 120% of GDP, and the US spends more on interest payments than on defense:

Chart: The rapidly rising blue line represents federal debt interest payments as a percentage of GDP, far exceeding defense spending.

The rapidly rising blue line in the above chart may now be the biggest budget issue.

This puts the Fed in a difficult position: it wants to use interest rate hikes as a tool to "cure" the government's fiscal problems, but the government's debt is so large that raising rates would be a poison pill, making the fiscal problems worse.

Of course, the Fed could take a chance.

But if raising rates leads to a further increase in the deficit, who would blink first: the Fed or the White House?

Before answering, consider that 73% of federal spending is now non-discretionary, compared to just 45% in the 1980s.

To believe that the Fed can win a showdown over the deficit is to believe that Congress is willing to make significant cuts to non-discretionary spending like Social Security and Medicare.

This seems, well, incredible.

Especially now, with a president who seems completely unfazed by the nation's growing debt.

This may stem from his experience as an over-indebted real estate developer in the 1990s.

"I guess it's the banks' problem, not my problem," Trump later wrote of his inability to repay his debts. "What the hell do I care? I even told one bank, 'I told you you shouldn't lend me money, I told you that damn deal ain't working.'"

Now, as president, when Trump tells Powell that interest rates should be lower, what he's really saying is that the national debt is the Fed's problem, not his.

He's not wrong.

“When interest payments on debt rise and fiscal surpluses become politically unfeasible,” writes David Beckworth, a former U.S. Treasury economist, “something has to give. That sacrifice is more debt, more money creation, or both.”

Yes, the Fed could resort to the Volcker/Greenspan maneuver and threaten Congress with higher interest rates.

But Powell probably knows that doing so would only exacerbate a problem that the Fed might eventually need to solve—and hasten the point at which it would be forced to do so.

“If debt levels are too high and continue to grow,” Beckworth explains, “the Fed’s role becomes to accommodate—either by lowering interest rates or by monetizing the debt.”

That, he warns, is the Fed’s true existential threat, not Trump: “When a central bank is forced to accommodate fiscal demands, it loses its economic independence.”

Beckworth remains hopeful that it might not come to that.

Perhaps not. We've seen how unpopular inflation is, so if there's another bout of it, voters might pressure lawmakers to address the deficit.

But he despairs that focusing on Trump's demands for lower interest rates is a red herring: "What we're witnessing is less about Trump himself than about the growing and unavoidable fiscal demands being placed on the Fed."

Trump was the first to articulate these demands, presumably because he knows the U.S. government's current fiscal policies are unsustainable.

But everyone knows that, even the government itself.

The only question now is: Who will deal with it?