What is the Biggest Threat to Fed Independence?
It’s not political attacks, mission creep, or operating losses. It’s the threat of fiscal dominance.
This week on the Macro Musings, podcast I spoke with Daniel Bunn of the Tax Foundation. We covered a wide range of topics including the impact of tariffs on government revenue, the budget reconciliation process, and tax code reforms. We also spent some time on the looming U.S. fiscal crisis—a challenge that neither political party seems prepared to address. According to the latest CBO baseline projections, the U.S. government is expected to run primary deficits of 2 percent of GDP per year over the next decade, while net interest payments rise to 4 percent of GDP, and the debt-to-GDP reaches almost 120 percent. The outlook only worsens in the following decade.
To be clear, there is no immediate fiscal crisis. But as Greg Ip recently noted in The Wall Street Journal, the rise in long-term Treasury yields — a move not explained by changes in expected Fed policy — suggests that “something fundamental has changed in the financial markets… Governments everywhere must pay up, and big budget deficits are more dangerous.” In other words, the bond market is beginning to take the fiscal outlook more seriously, especially as Congress considers the ‘Big Beautiful Bill’ that would raise the existing structural primary deficit over the next decade.
These developments raise a question: how will we know when we’ve reached the tipping point, the moment when fiscal pressures become a true macroeconomic constraint? One answer is that it will occur when fiscal dominance emerges. That is, when monetary policy is no longer focused on price stability, but on keeping the federal government solvent.
In this newsletter, I want to walk through what fiscal dominance is, how it differs from monetary dominance, and what it would mean if we crossed that line.
The Two Macroeconomic Policy Regimes
When economists talk about the interaction between monetary and fiscal policy, they often describe it in terms of which of the two is active and takes the lead in determining macroeconomic policy and which one is passive and adjusts to support the other’s lead. The table below summarizes the two possible macroeconomic policy regimes: monetary dominance and fiscal dominance.
Under monetary dominance, the central bank plays the lead role by actively adjusting interest rates to target inflation. The fiscal authority, Congress and the President, plays the supporting role by ensuring that taxes and spending adjust over time to keep government debt sustainable. In this regime, fiscal policy may run deficits in the short term, but over time it generates enough surpluses to “back” the debt. As my Mercatus colleague Eric Leeper puts it, monetary dominance works because fiscal policy doesn’t get in the way. It behaves passively to make room for the Fed to do its job.
Fiscal dominance flips this script. In this regime, the fiscal authority sets the course by deciding tax and spending paths without regard for whether they generate future surpluses. As a result, the central bank must accommodate that stance. If the fiscal path leads to rising debt and the political system is unwilling to adjust, the Fed may be forced to keep interest rates low or even monetize the debt to keep government finances sustainable. Put differently, in this regime fiscal policy determines inflation and monetary policy keeps the government solvent.
It is important to note that monetary policy and fiscal policy work together in both regimes. That means the notion of an “independent” monetary policy is a bit misleading. The Fed is only independent to the extent that fiscal policy is working passively in the background to keep the government solvent and thereby empower the Fed to take the lead. I will return to this point later.
Most advanced economies are currently in a monetary dominance regime and their monetary authorities assume it will stay this way. The Fed, for example, is explicit on this point when it says in its Statement on Longer-Run Goals and Monetary Policy Strategy that “The inflation rate over the longer run is primarily determined by monetary policy…” Governor Chris Waller was even more explicit about U.S. being in a monetary dominance regime in a 2021 speech:
[A] narrative has emerged that the Federal Reserve will succumb to pressures (1) to keep interest rates low to help service the debt and (2) to maintain asset purchases to help finance the federal government. My goal today is to definitively put that narrative to rest. It is simply wrong. Monetary policy has not and will not be conducted for these purposes… Deficit financing and debt servicing issues play no role in our policy decisions and never will.
It would be surprising if Fed officials said anything different given their responsibilities and the power of their words. However, never say never! The point of this newsletter is that the threat of fiscal dominance is looming over the Fed given the dire fiscal outlook. It would not be the first time the Fed has experienced fiscal dominance. I want to look back at these past experiences of fiscal dominance, with the help of the consolidated government budget equation, to see how it might unfold again.
The Consolidated Government Budget Constraint View
Let’s look at the government's budget constraint — not just the Treasury’s or the Fed’s separately, but the consolidated government budget. This view captures the full picture of how government spending is financed, whether through taxes, debt issuance, or money creation. The consolidated government budget constraint is:
Here Gt is government spending, itBt-1 is interest payments on outstanding bonds, Tt = tax revenue, ∆Bt is new bond issuance, and ∆Mt is non-interest bearing money creation. This identity must hold at all times, but how it is balanced tells us a lot about which policy authority is in the driver’s seat.
To see this, we can rearrange the equation to make the division of responsibilities more explicit:
On the left side are the parts the Fed controls: interest payments and money creation. On the right, is the fiscal stance: a combination of tax revenue, spending decisions, and debt issuance. The equal sign in this identity tells us that any change on one side must be offset on the other side. That is what makes this equation so powerful. It forces us to ask: who is adjusting to whom? And that brings us to the first regime: monetary dominance.
Monetary Dominance
The consolidated government budget constraint tells us that under a monetary dominance regime, fiscal policy must respond to the Fed tightening monetary policy. This can be seen below:
When the Fed tightens monetary policy by raising interest rates, it is also raising the financing cost of U.S. debt. Consequently, fiscal policy will have to run higher primary surpluses to pay the bill. New bond issuance could also temporarily paper over the gap, but markets will eventually demand fiscal backing, which means higher future primary surpluses:
Without the fiscal backing of current and future primary surpluses, the Fed would be forced to monetize (i.e. ∆Mt > 0) the higher financing cost. That would erode its credibility and loosen its grip on inflation. In other words: tightening monetary policy only works if it is fiscally supported.
This discussion should raise questions about the current elevated financing cost of U.S. debt. As noted above, the CBO expects net interest payments to run near 4 percent of GDP a year over the next decade. The Committee for a Responsible Federal Budget (CRFB) says the current budget proposals could push it past 5 percent by 2034. Under the CRFB’s scenario, interest payments would total $15.7 trillion between FY 2025 and 2034. How would it be financed?
In a monetary dominance regime, the higher financing costs would be financed by raising current and future primary surpluses. That, however, is not in the cards, per the CBO and CRFB. This means the Fed would have to start financing it with money creation that, in turn, would create higher inflation. Eventually, that would push macroeconomic policy into a fiscal dominance regime.
Fiscal Dominance
Under fiscal dominance, the roles reverse. The fiscal authority sets tax and spending paths without regard for long-term solvency. If Congress runs persistent deficits and markets begin to doubt fiscal solvency, the Fed will be forced to backstop fiscal policy. The Fed might suppress interest rates to reduce debt service costs or outright monetize debt by expanding its balance sheet. In either case, monetary policy becomes subservient to fiscal needs and loses control of inflation.
Fiscal dominance isn’t just a theoretical concern for the Fed , it is part of its history. From 1942 to 1951, the Fed operated under an explicit agreement with the Treasury to cap interest rates across the yield curve to support wartime financing. Short-term rates were held at ⅜ percent, and long-term rates were pegged at 2.5 percent. The interest rate caps can be seen in the figure below:
To maintain those caps, the Fed stood ready to buy Treasury securities in whatever quantity was needed, effectively monetizing fiscal policy. The Fed, in short, subordinated its inflation objective to the government's funding needs and, as a result, the price level eventually surged as can be seen below:
It wasn’t until the 1951 Treasury-Fed Accord that the Fed regained control of its balance sheet and its independence. That episode is a textbook case of fiscal dominance.
We also caught a glimpse of fiscal dominance during the COVID-19 crisis. As George Hall and Thomas Sargent have documented in a series of papers, the Fed rapidly expanded its balance sheet to absorb a surge of Treasury issuance, support financial markets, and hold rates near zero. For a time, it looked less like the Fed was leading policy than financing it. Fed officials may bristle at the idea that they were operating under fiscal dominance during the pandemic. However, the COVID crisis was a major public health war and fiscal dominance was arguably necessary.
What’s different now is that the fiscal picture is deteriorating absent any comparable emergency. The risks of fiscal dominance today stem not from a temporary shock, but from rising structural deficits and a political system that shows little appetite for course correction.
What Would Fiscal Dominance Look Like Now?
So what would fiscal dominance look like moving forward? Here are few possibilities:
Shift in Inflation Target Rhetoric: A subtle move away from the 2% inflation target, especially if framed around “debt sustainability”, would be a red flag.
Rising Inflation Risk Premiums: If markets demand higher yields on Treasuries independent of the expected path of Fed policy.
Yield Curve Control : The Fed caps long-term Treasury yields to keep debt service costs in check, as it did from 1942–1951.
End of Interest on Reserves: The Fed stops paying interest on bank reserves, turning them into zero-interest liabilities and expanding the inflation tax base.
Return of Reserve Requirements: Policymakers might reimpose reserve requirements, forcing banks to hold more non-interest-bearing reserves, effectively taxing the banking system.
Sustained Treasury Purchases: Renewed Fed buying of Treasuries, disconnected from macro goals, could signal monetization of fiscal deficits.
I suspect fintech, stablecoins, and crypto could give the public new ways to sidestep some of the consequences — like low-yield deposits, inflation taxation, and financial repression — of fiscal dominance. But this extra flexibility for the public might cause policymakers to double down on their efforts to make fiscal dominance work, including tightening control over financial innovation.
Charles Calomiris rightly notes that “Ultimately, the US may face a political choice between reforming entitlement programs and tolerating high inflation and financial backwardness.” That choice still lies ahead. But until we confront the growing costs of Social Security, Medicare, and other structural drivers of the deficit, it will be difficult to avoid drifting into a regime of fiscal dominance — not because of a crisis, but because the math leaves us with no other way out.
Brilliant piece, well done, David!
This was an exceptional breakdown of a topic that's often misunderstood or downplayed in policy circles. The distinction between monetary and fiscal dominance is more than academic—it has real implications for the sustainability of U.S. macroeconomic policy.