Trump and the Fed are on a collision course

The threat of “fiscal dominance” has been of mainly academic interest in recent decades, at least as far as advanced economies are concerned. People came to take for granted that central banks and monetary policy led the way on short-term macroeconomic policy, acting independently of governments to discharge their price-stability mandate and obliging fiscal policy to fall into line for stabilization purposes. This presumption of monetary dominance, if you will, has worked well, keeping inflation low at relatively little cost. Which is why it became so entrenched.

Before much longer, the U.S. seems likely to cast it aside. The conditions for fiscal dominance — when a central bank’s ability to control inflation through monetary policy is effectively negated by a government’s high debt and deficits — are falling into place.

The most familiar challenge to monetary dominance arises when curbing inflation demands both higher interest rates and higher unemployment. Price stability and maximum employment have equal standing in the Federal Reserve’s dual mandate, but operational independence lets the central bank decide how to strike the trade-off. The Fed, it’s understood, is willing to look beyond the short term and therefore gives future price stability greater weight than politicians. This understanding helps keep expected inflation anchored at or close to the Fed’s target rate of 2%.

Monetary dominance works because central-bank independence shields monetary policy from politics.

Most of the time, that’s fine. Conditions that call for moderate monetary tightening (or slower than expected easing) when the economy is strong don’t upset the formula. But having to tighten in the face of rising unemployment does. This scenario is now a distinct possibility, much as the Fed prefers not to think about it.

The Trump administration’s escalating trade war threatens a tariff-induced supply-side shock, which will bring both higher prices and higher unemployment. The central bank will have to decide whether the rise in prices is (cough) transitory. If so, it could choose to “look through” a brief spell of higher inflation and leave monetary policy unchanged; higher prices would mean lower real incomes, but there’d be no need for any further policy-induced rise in unemployment. However, if the trade shock caused longer-term expected inflation to rise (the University of Michigan’s latest survey is far from reassuring) “looking through” would be risky. The possibility of stagflation — inflation that is persistently above target plus less-than-full employment — makes the Fed’s balancing act all but impossible and shielding the central bank from politics much more difficult.

A second threat to monetary dominance arises when public debt gets too big for the central bank to ignore. Once the sustainability of accumulated public borrowing comes into question, the Fed must take into account the consequences of its interest-rate policy for projected budget deficits and financial stability. In effect, debt can rise to a point where it exercises a veto over higher short-term interest rates. The central bank finds itself having to acquiesce to higher inflation to limit the debt burden in real terms. The Fed doubtless understands the risks of starting a self-defeating cycle of higher inflation, higher long-term interest rates, and yet higher debt — otherwise known as hyperinflation. But it might choose to submit, or be forced to submit, in what it hopes would be a short-term expedient.

The Congressional Budget Office has just released its new long-term debt projections. They are dire. Budget deficits are expected to remain at 6% of GDP or higher indefinitely even with the economy at full employment. The ratio of public debt held by the public to GDP will reach 100% this year, rise to nearly 118% by 2035 (double the average between 1994 and 2025) and 136% by 2045 — then carry on rising. These plainly unsustainable numbers take no account of the impending extension of the 2017 Tax Cuts and Jobs Act, which will add another $5 trillion or so to the debt over the next 10 years, not to mention assorted other tax cuts that the administration and its enablers in Congress appear to have in mind.

In short, the budget outlook has fiscal dominance written all over it.

The third and final element is that President Trump may very well think that central-bank independence is wrong — and that he should put an end to it. Asserting control of supposedly independent agencies is already a driving theme of his second term. Most people think the Fed is a special case, but the president isn’t most people. With inflation proving stickier than expected, even before his tariffs fully kick in, he’s repeatedly called for lower interest rates. It’s easy to imagine this difference of opinion turning into an outright contest for control.

Trump could tell Congress to change the law to alter the Fed’s mandate and/or governance. Failing that, he can nominate allies to fill vacancies on the Federal Reserve Board. One such seat opens next January; and Jerome Powell’s term as chair ends the following May. Powell has said he won’t resign if Trump asks him to, and Trump has said he won’t try to fire him. But the law controlling these matters is disputed. A protracted fight over whether and how far the White House can direct Fed policy might be very much to the president’s taste.

Central bank independence is indeed a constitutional anomaly. It delegates politically freighted and enormously consequential choices to an unelected (and imperfectly accountable) branch of the executive. This anomaly has proved to be a very good thing, but that won’t decide the issue. Stagflation, soaring public debt and a president intent on asserting his political supremacy: A perfect storm is taking shape, and fiscal dominance is where it leads.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Clive Crook is a Bloomberg Opinion columnist and member of the editorial board covering economics. Previously, he was deputy editor of the Economist and chief Washington commentator for the Financial Times.