From calling for interest rate cuts to "fiscal dominance"? Trump's true aim in targeting the Federal Reserve may be "debt transformation"

As U.S. President Donald Trump attempts to further control the Federal Reserve's monetary policy, investors are beginning to worry that he will use the Fed's policy tools to address issues that should not be handled by the Fed, such as the ever-expanding debt bill of the U.S. government. Due to the widening budget deficit and rising interest rates, the total U.S. debt has skyrocketed in recent years.

On Tuesday, Trump stated that he is prepared to engage in a legal battle over his attempt to remove Federal Reserve Governor Lisa Cook and looks forward to having a "majority of rate-cutting seats" on the Federal Reserve Board. This could drive a series of campaigns by Trump to lower interest rates, which he claims will "save the country hundreds of billions of dollars."

There are two main reasons for the soaring cost of U.S. government debt in recent years: the continuously expanding budget deficit and higher interest rates. To keep the bills down, at least one of these must reverse. However, most economists say the solution lies in reducing government borrowing, achieved through some combination of cutting spending and raising taxes—rather than relying on the Fed to keep borrowing costs low.

Why has U.S. government interest expenditure surged? The debt has become larger—as the Fed raises interest rates, the cost of issuing bonds also becomes more expensive.

For the Fed, the latter path is undoubtedly a very dangerous move, as one of the Fed's core goals is to curb inflation. When politicians continuously inject funds into the economy to stimulate it, the task of combating inflation becomes even more difficult. If interest rates—the main lever for suppressing price pressures—turn into a tool for maintaining government solvency, then the task of combating inflation may become impossible.

Economists use the term "fiscal dominance" to describe this situation. It is often associated with emerging market countries, where monetary policy is more susceptible to political pressure. As Trump's assault on the Fed escalates, many analysts believe the U.S. is sliding in a similar direction.

Eric Leeper, an economics professor at the University of Virginia, believes this has already occurred. "Ultimately, if you want to control inflation, fiscal policy needs to be in place in the right way," said Leeper, a former Fed economist. Conversely, "What we are hearing now is that we need lower interest rates because interest expenditures are exploding," he stated. "This amounts to an admission that fiscal policy will not self-correct, so they are trying to find other ways out. This is fiscal dominance."

"This will not be a good thing"

Indeed, even investors and economists who are concerned about this risk do not all go this far.

There is no indication that interest rate decisions are being influenced by the state of U.S. public finances. To curb the persistently high inflation following the COVID-19 pandemic, Fed officials have implemented the most aggressive interest rate hikes since the 1980s—despite adding hundreds of billions of dollars in debt costs to the fiscal budget This year, as the Federal Reserve remains inactive amid concerns about inflation triggered by tariffs, Federal Reserve Chairman Jerome Powell insists that policy is entirely based on economic prospects, a point he reiterated in Jackson Hole. Powell has repeatedly stated that U.S. debt is on an unsustainable path. Last month, Powell told reporters that formulating policy based on government fiscal needs "would not be a good thing," adding, "No central bank in any developed economy would do that."

Nevertheless, there are growing concerns that the Federal Reserve may ultimately do just that. Under pressure from the Trump administration, Chairman Powell and the Federal Reserve governors may be forced to compromise. Even if the Federal Reserve does not compromise, it is only a matter of time before a compromise occurs, driven by the next Federal Reserve chairman nominated by Trump and more board members nominated by Trump.

Even if Powell does not compromise, as Trump will choose Powell's successor, the next Federal Reserve chairman may follow Trump's decision-making direction after taking office or continuously make speeches before officially taking office to influence market expectations. Powell's term as chairman will end in May next year.

Trump has nominated his economic advisor Stephen Miran to fill one of the vacancies on the board, and if he successfully fires Federal Reserve Governor Cook for alleged financial misconduct, it will create another vacancy. His team has hinted at a broader reshuffle of the Federal Reserve's FOMC policy committee and is looking for ways to exert more influence over the 12 regional Federal Reserve banks. Behind all this, the call for interest rate cuts remains persistent.

"The Federal Reserve is now facing an increasingly acute risk of fiscal dominance," wrote George Saravelos, global head of foreign exchange research at Deutsche Bank, in a report on Tuesday. "What surprises us more is that the market is not more concerned about this, especially since the stock market is pricing in this risk at all."

On Tuesday, as Trump pushed forward with plans to remove Cook, 30-year U.S. Treasury bonds and the dollar continued to decline. Earlier this year, both assets had reached lower levels driven by concerns over U.S. trade and budget plans, and they remain well above those lows.

Steve Barrow, G-10 strategist at Standard Chartered Bank, stated that there are concerns that a shift in the Federal Reserve's policy focus will weaken the dollar and raise bond yields, while potentially increasing investment interest in dollar alternative assets such as cryptocurrencies and gold.

A recent survey by Bank of America showed that more than half of fund managers expect the next Federal Reserve chairman to resort to quantitative easing or "yield curve control"—policies that involve purchasing government bonds to limit the upward movement of borrowing costs—to alleviate the U.S. debt burden.

"It's getting closer"

While pressuring the Federal Reserve, Trump and his allies have also proposed other ways to push down government debt costs.

A proposed tweak to bank capital rules could boost demand for U.S. Treasuries, thereby lowering their yields. New laws regulating stablecoins could also have the same positive effect, as the legislation requires issuers to back their assets with safe assets such as government debt U.S. government officials have also mentioned that issuing more short-term government bonds could save some costs. Republican Senator Ted Cruz has drafted legislation to prohibit the Federal Reserve from paying interest on reserves, claiming this would yield fiscal benefits.

According to David Beckworth, a senior researcher at the Mercatus Center at George Mason University, all of this is a sign that budget pressures are increasingly shaping policy. "We are not yet at the textbook definition of fiscal dominance, but we are getting closer," he emphasized. "I would say we are on that spectrum."

As for the budget itself, Trump pushed for a tax and spending bill this summer, known as the "Big and Beautiful" bill, which is expected to increase the deficit by $3.4 trillion over ten years. He has also opened up new sources of fiscal revenue through significant tariffs on imported goods.

S&P Global Ratings' latest conclusion is that the two factors essentially offset each other. "While we do not expect meaningful improvement in the fiscal deficit outcome, we also do not expect it to continue to worsen," the rating agency wrote.

S&P predicts that the budget deficit will remain around 6% of GDP during the remainder of Trump's term, which is generally consistent with other forecasting agencies. This is smaller than most periods post-pandemic, but still large by historical standards—twice the 3% target set by Treasury Secretary Scott Bessen.

The U.S. Treasury is expected to continue experiencing large deficits due to debt interest costs—CRFB estimates that the deficit will remain around 6% of overall economic output over the next decade.

This means that the total U.S. national debt will set a historical record of over 100% of GDP during peacetime. This increasingly large budget expenditure has accumulated under bipartisan governance, including bailouts during the global financial crisis and the pandemic, as well as hesitations to raise taxes or cut major budget items such as social welfare and defense.

When the government runs a deficit, it typically finances additional spending by issuing more bonds. At this point, the central bank begins to play a role: during crises, they can step in to directly purchase this debt. Even in normal times, central banks set short-term interest rates, which can potentially affect the cost of long-term sovereign debt.

However, the two do not always move in the same direction. "Regardless of what any particular country's government wants, ultimately interest rates are determined by the market," said Fabio Natalucci, director of the Anderson Institute for Financial and Economic Research. "Especially at the long end of the U.S. Treasury yield curve."

A recent example: when the Federal Reserve eased monetary policy at the end of last year, the yields on 10-year and 30-year U.S. Treasury bonds actually rose—partly due to concerns that a larger budget deficit and much greater tariff pressures from the Trump administration after the November elections would reignite inflation.

The cost of U.S. debt does not always move in sync with the benchmark interest rate set by the Federal Reserve—during the interest rate cut cycle in 2024, long-term U.S. Treasury yields are actually rising.

This situation reminds us that the Federal Reserve cannot automatically bring about lower government borrowing costs—it also reminds us that rising public debt can create significant problems for central banks, which prefer the bond market to remain sensitive to their actions.

Raphael Bostic, President of the Atlanta Federal Reserve, pointed out in July that if investors are concerned about fiscal risks, the effectiveness of monetary policy may decline. "You might see long-term Treasury yields fluctuate somewhat independently of our actions," he said. "That would be a real issue that we need to think seriously about."

"In this game of chicken, who blinks first?"

It is not uncommon for fiscal and monetary policies to point in opposite directions. The danger arises when both sides continue to apply pressure and are unwilling to make concessions.

"I see this as a 'chicken game,'" said George Hall, a professor at Brandeis University and former economist at the Chicago Federal Reserve. "Who will blink first? The Federal Reserve, Congress, or perhaps President Trump?"

For the Federal Reserve, it must win in this game to maintain its credibility as an anti-inflationary entity, even if it means keeping interest rates at historically high levels that exacerbate budget pressures. The so-called fiscal dominance occurs when the central bank fails in such a game—monetary policy becomes a tool for debt management, and the inflation target is diluted or even abandoned.

None of this currently applies to the United States. There are also no signs that the kind of economic emergencies that have led some countries into fiscal dominance are emerging.

On the contrary, the concerns are political—Dario Perkins, an economist at TS Lombard in London, emphasized that the questioning of the Federal Reserve and Trump's pressure on the Fed are "opening the door to that kind of regime."

"Trump has made it clear almost every week that the high interest rates maintained by the Federal Reserve are costing the government," he emphasized. "This is clearly related to the issue of excessive debt rather than simply the inflation problem in the U.S."