Trump’s ‘fiscal dominance’ play
The president is pressuring the Fed to lower rates to make deficits easier to finance. This could end badly, but for now investors are on board.
There is a potential spoiler to the growth dividend President Trump is counting on from the tax cuts that Congress just passed.
Those tax cuts will be financed by unprecedented borrowing. Textbook economics predicts that borrowing will push interest rates higher, neutralizing the benefits of lower tax rates.
Trump has an answer for that: break the link between budget deficits and rates. In recent weeks, he has intensified his demands that Federal Reserve Chair Jerome Powell cut rates, or step aside for someone who will.
Trump has always been, as he puts it, a “low interest rate person." But his latest demands add a critical new dimension—he wants lower rates to meet his fiscal priorities.
A flood of new bonds to finance deficits would normally put upward pressure on long-term interest rates. Trump’s Treasury is trying to short-circuit that mechanism, signaling that debt issuance will tilt toward shorter-term securities and Treasury bills.
This is a gamble. If short-term rates jump, the cost quickly hits the budget. Trump, though, doesn’t intend to let that happen. “We’re going to get somebody into the Fed who’s going to be able to lower the rates," he said on Fox News.
A central bank that shifts its priorities from employment and inflation to financing the government has succumbed to “fiscal dominance." It is usually associated with emerging markets that have weak central banks, such as Argentina. The result is typically some combination of inflation, crisis and stagnation.
Getting to that point, though, can take years. Meanwhile, fiscal dominance can be a powerful stimulant. While fiscal dominance isn’t yet the status quo in the U.S., the mere possibility might be influencing markets. Lower interest rates, aided in part by the prospect of a change in Fed leadership, coupled with deficit-financed tax cuts, have helped the stock market romp to new records.
The history of fiscal dominance
Central banks have long been intertwined with government finance. The Bank of England was founded in 1694 to help the monarchy raise money.
The Federal Reserve helped finance the U.S. government in World War I. At Treasury’s request, it capped interest rates during and after World War II. In the 1960s, it avoided tightening monetary policy while Treasury was trying to sell bonds, a practice that helped fuel inflation.
Since then, the Fed has avoided explicit coordination with fiscal policy. From 2008 to 2014, it did hold interest rates near zero and buy government bonds. This wasn’t fiscal dominance, because the Fed was acting on its own assessment of inflation, then below its 2% target, not on the instructions of the president.
Trump, unlike other presidents, expects the Fed chair to follow his priorities. Earlier this year, he flirted with firing Powell. He backed off after bond yields shot up and stocks sank. A few weeks later, the Supreme Court effectively said the president can’t fire a Fed governor (including the chair) without cause.
Trump then explored a different way to pressure the Fed: naming the next Fed chair, even though Powell’s term runs through next May. The idea is that markets, being forward-looking, would pay more attention to this “shadow chair"than Powell. And indeed potential successors are now openly making the case for lower rates.
It isn’t a given, of course, that Powell’s successor will do Trump’s bidding. Still, Trump is creative at finding ways to force institutions he doesn’t directly control to do as he says. Just look at universities and law firms.
The bond market pays attention
Back in May, House Republicans unveiled their version of Trump’s “one big, beautiful bill." It would have pushed the deficit from $1.8 trillion last year, or 6.4% of gross domestic product, to $2.9 trillion in 2034, or 6.8% of GDP, according to the Committee for a Responsible Federal Budget.
The U.S. has never before run such large deficits for so long. As bidding at Treasury bond auctions turned sloppy and Moody’s stripped the U.S. of its triple-A credit rating, 10-year Treasury note yields climbed to 4.55%.
The bill that passed Thursday is even more profligate: Deficits rise to $3 trillion, or 7.1% of GDP, in a decade. And if temporary tax cuts in the bill are extended, as the 2017 tax cuts have been, the deficit climbs to $3.3 trillion, or 7.9%, CRFB projects. And yet yields closed Thursday at 4.35%.
Yields have fallen for several reasons, including mild inflation and softer labor market data. But the prospect of a Trump-friendly successor to Powell seems to have played a part. Goldman Sachs economists recently concluded that the next Fed chair will be less worried about deficits than Powell and will thus lower rates further in the next few years.
If governments could borrow as much as they wished and set interest rates by fiat, why don’t more do it? Because there is no free lunch. If interest rates are persistently too low, something bad will happen, usually inflation.
Trump’s threats against the Fed have yet to shift investors’ expectations of future inflation. Perhaps they believe that no matter what Trump wants, the Fed will remain true to its mission. Even if they don’t believe that, it is expensive to fight the Fed. For all the mystique around “bond market vigilantes," markets won’t price in higher rates if the Fed is determined to keep them down.
More important, inflation has many drivers besides fiscal and monetary policy. As I wrote three weeks ago, mild inflation and cracks in the labor market (assuaged somewhat by the June jobs report) have boosted the case for a rate cut. Just because Trump’s call for lower rates is self-serving doesn’t mean it is wrong.
Still, history suggests that when a central bank over time follows a president’s dictates rather than its own judgment, the economy pays a price. Though maybe not soon enough to matter to the president.
Write to Greg Ip at greg.ip@wsj.com
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