By Davide Barbuscia
NEW YORK (Reuters) -As U.S. debt swells and the White House leans on the Federal Reserve to cut interest rates, investors are weighing the risk of “fiscal dominance,” a scenario where keeping government financing cheap eclipses the fight against inflation.
A budget bill passed last month by the Republican-controlled Congress is set to pile trillions onto the swelling U.S. debt load – raising the cost of servicing that debt. U.S. President Donald Trump has meanwhile made explicit calls for the Fed to cut rates, in part to lower the U.S. government’s interest costs.
The White House’s pressure campaign has raised concerns that the administration wants the Fed to return to a bygone era when it kept rates low in order to allow for lower-cost borrowing.
“(Fiscal dominance) is a concern … There are risks on the horizon, both from the perspective of increasing debt loads and the probability for higher structural inflation, or at minimum, more volatility of inflation,” said Nate Thooft, chief investment officer for equity and multi-asset solutions at Manulife Investment Management.
“The reason why the Trump administration and politicians in general … would like to see lower rates, is because it actually requires lower rates to be able to afford the debt levels that we have outstanding,” he said.
The U.S. experienced fiscal dominance during and shortly after World War Two, when the Fed was required to keep interest rates low for the war borrowing effort. The inflation spike that followed led to the 1951 Treasury-Fed accord that restored central bank independence.
High long-term Treasury yields and a sliding dollar already reflect that economic setup, some analysts say, as investors require more compensation to hold U.S. assets that could lose value if inflation rises.
“The administration wants to outgrow the debt … but the other way to deal with the debt is to inflate it away,” said Kelly Kowalski, head of investment strategy at MassMutual, who sees the dollar continuing to weaken.
Higher inflation would mean the real value of government debt shrinks.
Trump said last month that the Fed’s benchmark interest rate should be three percentage points lower than the current 4.25%-4.50% range, arguing that such a reduction would save $1 trillion per year. He separately said the central bank could raise rates again if inflation rose. In the 12 months through June, inflation as measured by the Personal Consumption Expenditures Price Index advanced 2.6% – still above the Fed’s 2% target.
Fed Chair Jerome Powell, however, has explicitly said that the U.S. central bank does not consider managing government debt when setting its monetary policy.
Some investors argue fiscal dominance lies on an uncertain horizon, with rising debt yet to trigger unsustainable interest rates, while others see it already seeping into markets as long-term yields remain elevated even amid expectations of Fed rate cuts.
White House spokesperson Kush Desai said the Trump administration respects the Fed’s independence, but that, with inflation having come down significantly from its highs in recent years, Trump believes it’s time to reduce rates.
The U.S. central bank so far has resisted those demands, though it is expected to lower borrowing costs at its September 16-17 meeting.
It declined to comment on this story.
FED’S MANDATE
The dollar is down about 10% this year against a basket of major currencies while Treasury term premiums – the extra compensation investors demand for holding long-term debt – are high, even as yields have recently dipped amid slowing economic growth.
“It’s difficult to be bullish (on) long bonds in this environment,” said Oliver Shale, an investment specialist at Ruffer, citing government spending that could keep inflation elevated and erode bond values.
“If you have an economy that’s running above its natural output, that’s going to result in inflation or have important implications for inflation, interest rates, and probably the currency,” he said.
Thooft at Manulife said he was bearish on long-dated Treasuries as higher inflation would require higher term premiums.
Despite years of economic growth, U.S. deficits have continued to balloon. Debt now stands at more than 120% of GDP, higher than after World War Two.
The Fed normally manages inflation while Congress maintains fiscal discipline. That balance inverts under the fiscal dominance scenario, with inflation driven by fiscal policies and a Fed trying to manage the debt burden, said Eric Leeper, an economics professor at the University of Virginia.
“The Fed cannot control inflation and keep interest payments on the debt low. Those are in conflict,” Leeper said.
One red flag for investors is the narrowing gap between interest rates and economic growth. Benchmark 10-year yields have hovered around 4.3% in recent weeks, while nominal GDP grew at an annual rate of 5.02% in the second quarter.
When interest rates exceed the growth rate, debt as a percentage of gross domestic product typically rises even without new borrowing, making the debt increasingly unsustainable.
“Risks to Fed independence stemming from fiscal dominance are high,” Deutsche Bank analysts said in a recent note, citing high deficits and long-term rates close to nominal GDP growth.
‘DOVISH BIAS’
History offers cautionary tales. Extreme fiscal dominance triggered hyperinflation in Germany in the early 1920s and in Argentina in the late 1980s and early 2000s. More recently in Turkey, pressure on the central bank to keep interest rates low undermined policy credibility and fueled a currency crisis.
A majority of economists polled by Reuters last month said they were worried the Fed’s independence was under threat. Despite a barrage of criticism from Trump and administration officials, Powell has vowed to remain Fed chief until his term expires in May 2026.
“It seems relatively clear that whoever is nominated for the seat, regardless of whatever views they’ve espoused in the past, is likely to articulate a dovish bias in order to be nominated,” said Amar Reganti, a fixed income strategist at Hartford Funds and former Treasury official.
Lower interest rates, however, might only be a temporary fix.
The administration may be hoping to “juice nominal growth,” despite the risk of creating higher inflation, to get to a place where real growth makes the debt trajectory sustainable, said Brij Khurana, a fixed income portfolio manager at Wellington.
“The problem they have is … the central bank is saying: ‘I don’t want to make that bet with you.'”
(Reporting by Davide Barbuscia; editing by Megan Davies and Paul Simao)
Comments