Is the Fed losing its independence?

It is Fed Day (again) and the Fed will continue to monitor the path of inflation and set its interest rate target accordingly. One thing the Fed is not going to do is listen to politicians and the government in how to set interest rates. Yet, while we take it for granted today that central banks set monetary policy and governments take these interest rates as a given, this may not continue to be like this.

Historically every country had episodes of what is commonly known as ‘fiscal dominance’, where the government’s fiscal policy forces the central bank to take actions it would otherwise not have done.

For example, in Turkey, President Erdogan believes that high interest rates lead to higher prices and thus inflation. When the central bank resisted his push for lower interest rates to reduce inflation, he rotated through three central bank presidents in two years before he found someone willing to do his bidding. The result is that official inflation rose from 15% at the start of 2021 to 85% in October 2022 (unofficial estimates are much higher than that) while the central bank cut policy rates from 19% to 9%. Only in the second half of 2023 did the central bank hike interest rates again (to more than 40%) which is slowly reducing inflation.

Turkey is a blatant example of fiscal policy dominating monetary policy. But there are subtler, but no less dramatic examples. In September 2022, then Chancellor Kwasi Kwarteng made a 30-minute budget statement. In that statement, he announced sweeping unfunded tax cuts as part of Prime Minister Liz Truss’ agenda to stimulate growth. Unfortunately, financial markets did not take well to these announcements and threw a massive tantrum. Sterling devalued rapidly while government bond yields rose more than 100bps in a couple of days. The massive convulsions in the bond market almost led to the collapse of several pension schemes and forced the Bank of England to announce bond purchases in unlimited amounts to stabilise the bond market. The problem here was that bonds only are valuable if investors believe that the debt will eventually be repaid by the government. If the government announces unfunded budget cuts it will have less money to pay its debt in the future and the risk of default increases rapidly. It’s as simple as that.

The US historically also went through periods of fiscal dominance. In 1933 the Fed went off the gold standard to stabilise financial markets while enabling the government to run massive fiscal deficits to fight the Great Depression and then finance the Second World War. Only in 1951 with the return to the implicit gold standard under Bretton Woods did monetary policy achieve dominance over fiscal policy again.

To be fair, emergencies almost always call for fiscal dominance where central banks adopt a monetary policy to stabilise financial markets and government debt. Whether we are talking about the bailouts during the financial crisis in 2008 or the rate cuts to support emergency spending during the pandemic, the Fed had to temporarily take actions that risk creating inflation later to save the economy from collapse today. But when your house is on fire you don’t complain to the firefighters about the water damage.

Yet, I think we are on our way to another major shift in the relationship between governments and central banks. For decades, we lived in an era of monetary dominance where central banks are actively trying to manage inflation while governments are passively setting fiscal policy accepting interest rates and the cost of debt as a given.

But the chart below shows that fiscal policy and monetary policy are more and more often in conflict, with one of them being expansionary while the other is restrictive. If such conflicts appear, either the central bank or the government must give in and change course or inflation will get out of control. If the Fed is tightening monetary policy but the government is increasing its deficit, the expansive fiscal policy risks creating more inflation. In the end, the Fed will be forced to assert its dominance by hiking interest rates even more until inflation is under control.

Fiscal and monetary policy in the US and periods of conflicting policies

Source: Liberum, Bloomberg

Americans tend to think of Ronald Reagan as a tax-cutting President. Yet after the 1981 Economic Recovery Tax Act which increased the deficit by $111.4bn per year in the first four years the Fed reacted to the subsequent increase in inflation by hiking rates aggressively forcing an about-face and seven tax hikes by the Reagan and Bush Sr. administrations that reduced the deficit by a combined $156.5bn per year. In the fight between the government and the Fed, the Fed won, and monetary dominance was preserved.

However, I fear that in the coming decade, the Fed may lose its dominance over fiscal policy, and we will see a gradual shift towards fiscal dominance again. The disastrous mini-budget of Kwasi Kwarteng was a shock event, but with debt loads being as high as they are and the US government making no efforts to cut its budget deficits in any meaningful way, the Fed will increasingly have to take debt sustainability into account when setting interest rates.

If the Fed wants to prevent a slow-motion version of the debt crash under Liz Truss and Kwasi Kwarteng in the UK, it will increasingly have to limit interest rate hikes to levels that do not endanger bond market stability. Which in turn means that the fight against inflation will become more difficult. I have described how such a monetary policy of the future could look like here, and last week, I emphasised that the Fed will likely have to follow in the footsteps of Japan if it wants to avoid a financial crisis in the US. This means that consciously or unconsciously, fiscal policies will become more and more dominant over time, reducing the independence of monetary policy and making inflation harder to control. And where inflation becomes harder to control, you can be assured inflation will at least become more volatile.