Trump’s Self-Destructive Fight with the Fed for Low Interest Rates: His “Fiscal Dominance” Game of Chicken

Donald Trump holds many contradictory beliefs and pursues them with vigor rather than making tradeoffs. A prominent example is his fight with Fed chair Jerome Powell over interest rates. Trump wants them lower because he thinks it will reduce inflation and be good for business.

So far, Trump has been losing. The central bank has been holding the line since the economy still seems strong and Trump’s tariffs are destined to have an inflationary impact (although how much is yet to be determined). Trump’s threats to fire Powell led interest rates to notch up, so he has backed off and is sulking by engaging in a range war with Powell. Trump has harrumphed that he will replace Powell in 2026 and will even name a shadow Fed chair to try to contest Powell’s authority. I anticipate that will be as effective as the out-of-power party speeches right after the State of the Union.

Interest rate policy has come into even more intense focus with the passage of Trump’s “big beautiful bill” which sets the US on a path of yawning budget deficits when there were already worries a plenty over the sustainability of US debt levels. As we will soon explain below, some pundits have depicted Trump as engaging in a fiscal dominance strategy, of forcing the Fed to weigh funding, as in interest rate, costs, heavily in setting its interest rate policy. World War II is a precedent; the Fed kept interest rates at 2% for much of its duration. But though wholesale prices rose at an average rate of over 8%, real incomes were also increasing by an average of over 4%. So this bout of inflation did not damage the financial position of workers.

Not only does our current situation not resemble that of the US on a total war footing, but as we have explained repeatedly, the idea that putting money on sale via low interest rates is a boon to productive activity is misguided, as widespread and protracted ZIRP/low rate experiments have shown. High interest rates will choke business borrowing and thus crimp some activities, witness the famed quip by former Fed chair William McChesney Martin, ““The Federal Reserve…is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

But low rates do not simulate activity, or at least not the sort that is terribly desirable. Businesses do not take the risk of borrowing to expand their activities just because the price of money fell. Their first consideration is whether commercial opportunity, such as expanding geographically or launching a new product, exists. They then weigh any funding cost as part of this assessment (recall the biggest source of funds for businesses is retained earnings, and not the use of debt).

So what enterprises might go out and expand if interest rates are low, particularly in real terms? Ones where interest expenses are the biggest, or one of the biggest, expenses. That means leveraged speculators, like private equity, hedge funds, banks…and real estate developers. So at best, Trump is generalizing from personal experience, which is not applicable to the economy as a whole. Of course, he may also be unduly responsive to the pleas of big financier donors who benefit from low interest rates.

Trump might hope for lower interest rates boosting the economy via mortgage refis. This was a big stealthy source of stimulus in the post financial crisis period. The Wall Street Journal even has a fresh front page story lamenting how many recent homebuyers made the bad bet that they could buy a house at a somewhat favorable price due to elevated mortgage rates, then refi when their hoped-for rate decline materialized. From Homeowners Who Gambled on Lower Rates Are Paying the Price:

This real estate adage that a buyer should “marry the house and date the rate” has often worked in the past. Millions of homeowners refinanced in 2020 and 2021 when mortgage rates fell to historic lows. Many of them saved hundreds of dollars a month on mortgage payments.

But rates haven’t dropped below 6% since September 2022, and economists don’t expect a return to the lows of a few years ago.

With mortgage rates staying higher for longer, those who had hoped to refinance within a year or two are stuck. The housing market remains divided between homeowners who locked in cheap borrowing costs and those who are burdened by higher monthly payments…..

And if rising tax or insurance costs have pushed up homeowners’ monthly payments while their incomes haven’t changed, that could make it difficult for them to qualify for a new loan.

The problem with the line of thought is that “policy” rate cuts may not translate into much if anything in the way of declines in interest rates at longer maturities. Mortgage rates are typically set off the “belly of the curve” as in the 7 year rate. And in the early 1990s, Greenspan dropped short-term interest rates very low, the back end of the curve did not move much. Here, with pretty much every financially literate person in the US expecting the durable and rising inflation between Trump’s massive fiscal stimulus and tariffs goosing many costs, it’s hard to fathom how the Fed relenting on rates have much impact on intermediate and longer-term interest rates.¹

Admittedly, if the US engineers persistent high inflation, banks may start to offer floating rate mortgages as they did in the later 1970s and early 1980s. This product has acceptable risk if the mortgage has interest rate ceilings and floors (mine did).

The low mortgage rates of the post crisis period were THE reason for QE. Bernanke kept explaining, and too few listened, that the Fed was buying longer-dated Treasuries and high quality mortgage securities, such as Fannies and Freddies, to target mortgage interest spreads. The Fed was at the front line of the operation to restore housing prices via favorable mortgage interest rates. Many borrowers were “under water” as in the current value of their house was lower than their mortgage balance. The fear was that if these homeowners would default if they were under financial stress, since they could reasonably see themselves as throwing good money after bad in trying to keep their house.²

Even though they are too committed to Trump’s incoherent scheme to admit it, Treasury Secretary Scott Bessant’s plan to opportunistically (as in for the foreseeable future) fund at the short end of the curve is lowering investor confidence in Trump’s policies. Lower confidence = higher perceived risk = higher required return = higher interests rates. From Bloomberg in Bessent Is Treating Treasury Like a Hedge Fund:

Two things can be true at the same time: First, Treasury Secretary Scott Bessent is generally right to avoid terming out the US government’s debt at the high prevailing borrowing costs. Second, he is being hypocritical given that he criticized his predecessor for leaning into short-dated bill issuance.

Here’s Bessent’s exchange on Monday with Bloomberg’s Sonali Basak:

Basak: At what point do you start issuing at longer-dated maturities?<

Bessent: Well, why would we do it at these rates? We are more than 1 standard deviation above the long-term… rate, so why would we do that? The time to have done that would have been in ’20, ’21, ’22.

As a matter of tactics, I increasingly agree with Secretary Bessent, who no doubt has plenty of experience timing the market from his years as a hedge fund manager….

All of that can be true, but Bessent is still openly flouting the standards of Treasury market issuance. When Janet Yellen was leading Treasury, Bessent criticized her for precisely the policy that he’s now pursuing. Bessent claimed that Yellen was being fiscally imprudent by pushing up sales of short-dated bills. While bills have lower interest costs than notes and bonds (in normal yield curves), they mature sooner and open up the government to volatility over the short- and medium-run….

Bessent is now openly bucking the time-honored Treasury principle of “regular and predictable” funding. Some four decades ago, Treasury officials decided that regular and predictable — as opposed to tactical — issuance decisions were among the best ways to keep government funding costs at their lowest possible levels over time. Since then, Treasury has declared quite explicitly that it doesn’t seek to time the market.

How common is this view? I have no idea. But Trump’s tariff fixation whipsaws alone give reason to question the competence of his economics team. Beating up on Powell and desperate-looking Treasury funding approaches can’t help.

Now to the “fiscal dominance” issue, that Trump intends to force the central bank’s hand and lower rates to accommodate his yawning fiscal deficits and funding needs.³ From Wall Street Journal economics editor and Fed whisperer Greg Ip in Trump’s ‘Fiscal Dominance’ Play:

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….

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….

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…

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.

Ip’s orthodox account is not correct. One reason unduly low rates come to tears is that they fuel speculative asset bubbles, which when they implode, do great damage to asset holders. They severely rein in spending, producing an acute recession or even a depression.

A particular adverse scenario here is that the Trump yawning deficits won’t fund much in the way increases in productive capacity. So the great increase in demand produced by such large net fiscal spending with no corresponding increase in economic capacity will directly increase inflation.⁴

John Authers at Bloomberg has a similar discussion, although his piece is framed around the notion that central bank independence is the least bad approach on offer:

With the US now bearing its highest peacetime debt load in history, Trump wants monetary policy to be subjugated once again to the needs of managing official debt. Forcing the public to lend to the government at unrealistically low rates of interest is one way to deal with the deficit — but the spectacle of the One Big Beautiful Bill shows that there’s value to an independent central bank empowered to tell politicians they’re not going to help them avoid difficult choices. No wonder foreign traders are losing their faith in the dollar.

The St. Louis Fed, in a paper by banking expert and regular industry advocate Charles Calomiris, in Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements, gives the “Beyond here lie dragons” view of fiscal dominance. Nevertheless, he usefully points out that in sustained period of fiscal dominance, central banks have an ugly tendency to use more and more bank reserves to shore up their operations. Mind you, this practice is based on the widely-held yet disproven loanable funds theory, that borrowings come from a pre-existing pool of savings, as opposed to are created ex nihilo. Key parts of the paper:

Under current policy and based on this report’s assumptions, [government debt relative to GDP] is projected to reach 566 percent by 2097. The projected continuous rise of the debt-to-GDP ratio indicates that current policy is unsustainable.

—Financial Report of the United States Government, February 16, 2023

The above quotation from the Treasury’s Financial Report admits that the current combination of government debt and projected deficits is not feasible as a matter of arithmetic because it would result in an outrageously high government debt-to-GDP ratio. But when exactly will the US hit the constraint of infeasibility, and how exactly will US policy adjust to it?…

Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low. …

The essence of fiscal dominance is the need for the government to fund its deficits on the margin with non-interest-bearing debts. The use of non-interest-bearing debt as a means of funding is also known as “inflation taxation.” Fiscal dominance leads governments to rely on inflation taxation by “printing money” (increasing the supply of non-interest-bearing government debt). To be specific, here is how I imagine this occurring: When the bond market begins to believe that government interest-­bearing debt is beyond the ceiling of feasibility, the government’s next bond auction “fails” in the sense that the interest rate required by the market on the new bond offering is so high that the government withdraws the offering and turns to money printing as its alternative….

If the US government faced a fiscal dominance problem, it would have to fund real deficits by real inflation taxation, which is a limited tax resource. Thus, not all real deficits are feasible to fund with inflation taxation…

Given the small size of the currency outstanding, if the government wishes to fund large real deficits, that will be easier to do if the government eliminates the payment of interest on reserves. This potential policy change implies a major shock to the profits of the banking system.

Second, as the history of inflation episodes has shown, even an inflation tax base of currency plus zero-interest reserves would decline in real terms in the face of a significant increase in inflation. Based on data for the US as of 2023, the resulting inflation rate could be very high…

For that reason, it is quite possible that a fiscal dominance episode in the US would result in not only the end of the policy of paying interest on reserves, but also a return to requiring banks to hold a large fraction of their deposit liabilities as zero-interest reserves. For example…requiring banks to hold 40 percent of deposits as zero-interest reserves, under reasonable assumptions, would reduce the annual inflation rate to fund likely deficits from an inflation of about 16 percent to only about 8 percent….

The history of inflation taxation around the world has shown that when governments become strapped for resources, they often use zero-interest reserve requirements to tax banking systems and remove their spending constraints…

Taxing banks with reserve requirements and zero-interest reserves is convenient for two reasons. First, instead of new taxes enacted by legislation (which may be blocked in the legislature), reserve requirements are a regulatory decision…

Second, because many people are unfamiliar with the concept of the inflation tax (especially in a society that has not lived under high inflation), they are not aware that they are actually paying it, which makes it very popular among politicians…

Such a policy change would not only reduce bank profitability but also reduce the real return earned on bank deposits to substantially below other rates of return on liquid assets, which potentially could spur a new era of “financial disintermediation,” as …occurred in the US in the 1960s and 1970s.

There’s a lot wrong with this orthodox tale, but it’s likely to prove popular as normal mechanisms for funding Trump’s spending excesses run into more and more difficulty. One is Calomiris acting as if paying banks to hold reserves is a sound practice. It isn’t. It was a post-crisis scheme to subsidize banks; the nominal reason was to have a “better” way to manage short-term interest rates (the very long-established mechanism was to have the New York Fed act directly in the market, buying and selling Treasuries). In keeping with the interest on reserves not being such a hot idea, the 2019 repo panic was the direct result of the Fed engaging in its first-time-ever tightening under its interest-on-reserves regime. Mere months earlier, the two most senior members of the Fed’s New York money markets desk had abruptly resigned, one wonders over having sounded warning about what might go haywire in a tightening cycle with new mechanisms. That meant a dearth of seasoned hands on deck to stabilize markets the old-fashioned way.

However, Calomiris is probably correct that banks will suffer adjustment pains if they were denied their “interest on reserves” subsidy.

A second looming issue is that Calomiris fails to see that bond issuance to fund Federal spending in excess of receipts is a political convention, a holderover from the gold standard era, and not an operational necessity. Reader Karl did a fine job of debunking that idea in a recent post:

“The government still has to borrow money from somewhere.”

This is current practice, but MMT says (and I agree) that the sovereign has the discretion to depart from this practice and “spend money into existence”. The idea of borrowing and paying interest is a matter of sovereign choice, and it increasingly appears to be an arbitrary (but very expensive) choice that now costs the U.S. $1 trillion/yr in interest charges.

If you have an exclusive right to the issuance of the only universal reserve currency, and pay zero interest, other Sovereigns will still choose to hold it as a “reserve” up to a point — but not excessively so. In this way countries with trade surpluses will have every incentive to let their currencies appreciate once they have the “rainy day” reserves they need to keep the IMF off their backs. It is our outmoded legacy system from the days of the gold standard that maintains the fiction that we must “bribe” the world with interest to hold dollars, and therefore the interest-bearing debts keep piling up and the trade deficits continue.

If the U.S. government were to announce, tomorrow, that it would henceforth monetize all deficits; cease selling debt securities; and let all bonds expire at maturity, eventually the interest charges on the entire U.S. debt will go to zero.

When will such a policy be instituted? When interest charges go to $2 trillion? $10 trillion? The total keeps growing faster than GDP, so it seems the “debt singularity” will happen eventually.

The gold standard is not dead. We just adhere to the same rituals as if the dollar had to be as precious as gold, more precious than health care or other safety nets. Republicans today think, a la Grover Norquist in years past, that all this social spending is like so many unwanted kittens, and deserve to be drowned in the fiscal (blood) bath. Republicans can see the day of reckoning coming when we’ll drown those kittens so we can keep paying those interest charges. They are patient.

We have to start discussing the alternatives. Japan has shown the way. All we have to lose is our chains to a bygone era.

Sadly, Trump’s lack of attachment to norms is not likely to extend to government financing, at least in ways that could prove beneficial.

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¹ There is always the risk of a Great Depression level crash, which would severely depress economic activity and inflation pressures. So there is a scenario where low rates are again the order of the day, but it’s not a pretty one.

² At the time, we argued fiercely that this “strategic default” meme was vastly overdone, since defaulting on a mortgage, aside from the personal upheaval, was very damaging to one’s credit ratings and employment prospects. We did think that there were “anticipatory defaults” as in borrowers halting payments before they were completely out of money so as to have some cash in the till so they could move into a rental.

³ Yours truly doubts this is a Trump plan, as opposed to the result of his various actions.

⁴ A colleague argues that one reason the Administration hearts crypto is that it drains money supply. The wee problem is that despite the many economists and media banging on regularly otherwise, money supply increases do not cause inflation. See Japan as the textbook case. That fact was demonstrated decades ago via monetarist experiments under Thatcher and Reagan. Monetary velocity is not remotely stable so theories based on money supply having macroeconomic effects are bunk.