The Consolidated Government Budget Constraint Does Not Care About Your Fed Independence Feelings
Missing the Fiscal Forest for the Trump Trees
George Hall returned to the podcast this week to discuss the long-run fiscal consequences of the U.S. response to COVID-19. Drawing on his work with Tom Sargent, Hall framed the pandemic response as a public health “war” and compared its financing to that of previous major U.S. wars.
Hall noted that unlike earlier conflicts—such as the Civil War and World Wars I and II—where the federal government financed wartime expenditure surges through a mix of increased taxation, bond issuance, money creation, and postwar primary surpluses, the COVID-19 response marked a sharp departure from historical precedent. While monetary expansion and inflation have always played some role in wartime finance, past episodes generally included a follow-up phase of fiscal consolidation. In contrast, the pandemic response leaned overwhelmingly on overnight borrowing and monetary expansion, as reflected in the table below from Hall and Sargent (2023). Moreover, there has been no serious attempt at fiscal consolidation in the years since the pandemic, only continued primary budget deficits.
At the heart of our conversation was a crucial macroeconomic identity: the consolidated government budget constraint. This identity must hold. Uncle Sam ultimately has to cover his real obligations. There is no free lunch.
Understanding this constraint helps clarify what is really going on in the current debate over Fed independence. Many, if not most, observers view President Trump’s public, persistent, and performative demands for Chair Powell to cut interest rates as an attack on the Fed’s political and legal independence. That view, however, misses the fiscal forest for the Trump trees.
Trump’s calls for interest rate cuts today are very different from those in 2019. They are not driven by business cycle concerns but by mounting fiscal pressures. As George Hall notes, these pressures have been building since the early 2000s and would be here regardless of who occupies the White House. Yes, Trump brings extra theater—and he is adding to the imbalance with his One Big Beautiful Bill—but the broader fiscal trajectory was already locked in. It is unlikely that a Democratic president would have materially improved the path either.
So, in my view, what we are witnessing is less about Trump himself and more about the growing and unavoidable fiscal demands being placed on the Fed. In the remainder of this post, I will unpack that argument further and explore what kind of Fed independence is truly at risk. But for now, here is a video clip from the podcast that highlights one powerful implication of the consolidated government budget constraint.
The Four Types of Fed Independence
As noted above, many observers are worried about the Fed’s independence being weakened under President Trump. A good example of this comes from former Fed chairs Ben Bernanke and Janet Yellen, who wrote in a recent New York Times article:
As former chairs of the Federal Reserve, we know from our experiences and our reading of history that the ability of the central bank to act independently is essential for its effective stewardship of the economy. Recent attempts to compromise that independence, including the president’s demands for a radical reduction in interest rates and his threats to fire its chair, Jerome Powell, if the Fed does not comply, risk lasting and serious economic harm. They undermine not only Mr. Powell but also all future chairs and, indeed, the credibility of the central bank itself.
Bernanke and Yellen define Fed independence as the Fed being able to make monetary policy decisions “without regard to short-term political pressures.” That, however, is only one dimension of Fed independence and in my view, not the important one that is now at risk.
To fully understand the nature and fragility of Fed independence, I find it useful to categorize independence into four buckets: legal, political, financial, and economic. Legal independence stems from the statutory protections embedded in the Federal Reserve Act. Political independence refers to the informal norms that discourage elected officials from interfering in the Fed’s policy decisions. Financial independence captures the Fed’s ability to fund itself without congressional appropriations, while economic independence concerns the Fed’s freedom to pursue its dual mandate without being constrained by unsustainable fiscal policy. The table below provides more details on these four forms of Fed independence:
Economic independence is foundational to all other forms of central bank independence. In modern central banking, it is often taken for granted. Not since the 1942-1951 period has the Fed experienced a sustained threat to its economic independence. That historical distance may explain why many observers reflexively focus on political and legal independence. But the deeper issue today is the erosion of economic independence. And, as the sinking ship figure above illustrates, once that foundation begins to crack, the other forms of Fed independence inevitably begin to falter as well.
We see this clearly in the motivation behind President Trump’s current calls for interest rate cuts. He is not concerned with the Fed’s dual mandate. He says the economy is hot. Inflation is low. His focus is on reducing the government’s interest payments.
This stands in stark contrast to 2019, when his rate-cut demands were about stimulating the economy.
As noted earlier, these fiscal pressures have been building for decades. They would be here regardless of the president. Yes, Trump’s style adds pressure, but no modern president could escape the political realities tied to the debt path.
To fully grasp the implications for the Fed, we must turn to the consolidated government budget constraint. It highlights the inescapable arithmetic linking the Treasury’s fiscal decisions and the Fed’s monetary tools.
Why the Fed’s Economic Independence is at Risk: the Consolidated Government Budget Constraint
The government's consolidated budget constraint shows how government spending is financed—whether through taxes, debt issuance, or money creation. The consolidated government budget constraint is as follows:
Here Gt is government spending, itBt-1 is interest payments on outstanding government bonds, Tt = tax revenue, ∆Bt is new government bond issuance, and ∆Mt is non-interest bearing money creation. This equation can be rearranged to make clear the division of monetary and fiscal policy:
The Fed controls interest payments and money creation on the left-hand side of the equation. Congress and Treasury determine the tax revenue, spending decisions, and debt issuance. The equal sign tells us that any change on one side must be offset on the other side. This macroeconomic identity must hold at all times. To illustrate this point, consider two scenarios:
Scenario 1: Fed Tightening with No Expected Primary Surpluses
Consider the case of the Fed tightening monetary policy by raising interest rates. To see the fiscal implications of Fed tightening, we rearrange the consolidated government budget constraint to isolate interest rates:
The tightening of monetary policy means higher financing costs for U.S. public debt. It can be financed by running primary budget surpluses, incurring more debt, creating more money, or some combination of the three:
Since primary budget surpluses are unlikely in the United States, that only leaves debt and money creation. Debt, however, has to be repaid and in a world with no primary surpluses that means future money financing of the current debt. Plugging this back into our equation we end up with the following:
In plain English, higher interest costs on U.S. debt are going to be financed with current and future money creation in a world with no primary surpluses. If that money creation exceeds the real demand for money, then inflation will follow.
Note that the larger the stock of U.S. debt, Bt-1, the more likely there will be excess money creation that turns into inflation. Given the outlook for U.S. primary budget deficits and the national debt, this scenario should give you pause.
Scenario 2: Undermining the Fed’s Economic Independence
For the Fed to maintain economic independence, it must set policy without being constrained by fiscal solvency concerns. That requires the Treasury to passively accommodate the Fed. But if debt levels are too high and growing, it becomes the Fed’s job to accommodate—by suppressing interest rates or monetizing debt. In either case, monetary policy becomes subordinate to fiscal needs, loses its economic independence, and loses control of inflation. The consolidated government budget constraint holds again:
This is fiscal dominance. And it is not hypothetical. We are already seeing early signs:
Trump’s pressure for rate cuts
The push to relax the SLR (Supplementary Leverage Ratio)
The fiscal rationale behind stablecoin adoption
Some may dismiss these examples. But ask yourself: would we even be having these discussions if the U.S. debt-to-GDP ratio were 50% instead of 100%? The answer is almost certainly no.
Conclusion
The fiscal forest is burning and too many observers are fixated on the Trump trees. Yes, his showmanship and public browbeating of the Fed deserve scrutiny. But if we stop there we risk missing the deeper, more consequential story.
That story is about arithmetic. It is about the inescapable logic of the consolidated government budget constraint. When interest payments on the debt rise and primary surpluses are politically off the table, something else has to give. That something is more debt, more money creation, or both. And when the central bank is forced to accommodate fiscal needs, it loses its economic independence. When that goes, the political, legal, and financial independence of the Fed will not be far behind.
This is not a partisan problem. It is not just about Trump. It is the result of decades of fiscal drift, demographic pressures, political gridlock, and wishful thinking. The constraint does not care who sits in the Oval Office or chairs the FOMC. It cares only about balance between promises and resources, between obligations and tools.
If we want to preserve central bank independence, we must first acknowledge the quiet but growing force that undermines it: fiscal unsustainability. Until then, everything else is just noise.
The Fisher Effect must also play a role? Will it exacerbate the problem as we approach Fiscal Dominance?
Great post, David. It sounds very similar to what fiscal theory of the price level proponents are saying.