This episode reveals how unprecedented government debt is forcing a new reality where fiscal needs are beginning to dictate Federal Reserve policy, pushing the U.S. into the early stages of fiscal dominance.
Defining Fiscal Dominance vs. Monetary Dominance
- Monetary Dominance: This is the regime most have grown up in, where the Federal Reserve acts independently to maintain price stability (e.g., a 2% inflation target). In this world, fiscal policy (Congress, Treasury) works in the background to ensure the government remains solvent. The Fed takes the lead on managing the economy.
- Fiscal Dominance: This occurs when the roles flip. Government debt and deficits become so large that the Fed's primary mission shifts from controlling inflation to ensuring government solvency. The Treasury and Congress effectively determine the price level through their spending and debt issuance, while the Fed is forced to keep interest rates low to manage the debt burden.
- Beckworth warns, "The danger is we're getting awfully close to those roles being flipped." This transition isn't an on/off switch but a gradual process with clear warning signs.
Historical Precedents for Fiscal Dominance
- The Treasury Accord of 1951: The clearest historical example followed World War II. The Fed was tasked with its "patriotic duty" to finance the war effort.
- This involved Yield Curve Control (YCC), a policy where the central bank pegs interest rates at specific levels across different maturities. From 1942 to 1951, the Fed actively bought government debt to keep both short-term and long-term rates fixed and low.
- The 2021 Pandemic Response: Beckworth argues that 2021 represented a "brief period of fiscal dominance." The Fed stepped in to fight a "global health war," purchasing most of the newly issued Treasuries and keeping rates near zero, even as the economy began to recover strongly.
The Catalysts Driving Fiscal Pressure Today
- The U.S. is running $2 trillion deficits during peacetime and at full employment—a historically unprecedented situation.
- The national debt is approximately 100% of GDP and projected by the CBO and other organizations to reach 120-130% within the next decade.
- Beckworth attributes this to a long-term "inability for the body politic... to make tough choices," enabled by decades of low global interest rates that made it easy to "kick the can down the road."
The Three Stages of Fiscal Dominance
- Stage 1: Monetary Dominance. Normal times, where the Fed is in control of price stability.
- Stage 2: Balance Sheet Financial Repression. This stage begins when debt-to-GDP is in the 100-120% range. The financial system's balance sheets (central bank, commercial banks) are drafted to help finance the government.
- Examples in Action:
- Regulatory Changes: Pushing to lower the Supplemental Leverage Ratio (SLR) for banks, which reduces the capital cost of holding Treasuries and encourages them to buy more government debt.
- Political Rhetoric: Former President Trump's recent pressure on Fed Chair Jay Powell is now explicitly tied to lowering the government's debt financing costs. Beckworth notes, "Trump is explicitly tying his pressure on the Fed to the cost of the debt. That's fiscal dominance rhetoric."
- Policy Proposals: Senator Ted Cruz's call to eliminate interest on reserves is another example of policy being driven by fiscal pressure.
- Stage 3: Outright Fiscal Dominance. This is the final phase, characterized by clear interest rate suppression, higher inflation, and a softening of the Fed's inflation target to accommodate fiscal needs.
Stablecoins: An Unwitting Tool for Fiscal Dominance?
- For crypto investors, the discussion on stablecoins provides a critical strategic insight. Their growth could be co-opted as a tool for financial repression.
- Stablecoins function like global money market funds, and their reserves are predominantly held in short-term government debt like Treasury bills.
- Beckworth suggests that from a cynical perspective, the U.S. government may support stablecoin legislation because it "will expand the market for Treasury bills," creating a new, captive buyer base for U.S. debt.
- He argues stablecoins will create net new demand for dollar-denominated assets, particularly from international users seeking stable transaction assets and cheaper cross-border payments, thereby strengthening dollar dominance and the demand for its underlying collateral (Treasuries).
Treasury's Debt Strategy as a Sign of Pressure
- The U.S. Treasury's own debt management strategy is another indicator of Stage 2 fiscal dominance.
- The Treasury is increasingly issuing short-term Treasury bills instead of long-term bonds.
- This is a direct response to higher financing costs. Because the yield curve is often upward-sloping, issuing short-term debt is cheaper.
- This strategy, while rational for minimizing taxpayer costs, reflects the mounting pressure from the enormous stock of outstanding debt.
The Endgame: Stage 3 and Yield Curve Control
- Yield Curve Control (YCC) would be a definitive sign of Stage 3. It is distinct from Quantitative Easing (QE). QE involves buying a fixed quantity of assets, whereas YCC involves buying any quantity of assets needed to peg interest rates at a specific target.
- This would force the Fed to massively expand its balance sheet to absorb government debt and suppress rates.
- Other "implicit taxes" could be imposed on the financial system, such as forcing banks to hold zero-interest reserves or placing caps on deposit rates, as was done in the U.S. before the 1980s.
- Beckworth states, "One way or the other, real resources have to be gathered to pay for the expenses we incurred in the past. You either tax through higher collections, or you tax through inflation, or you tax the financial system."
The Fed's Evolving Monetary Framework
- Amid these fiscal pressures, the Fed is reviewing its monetary policy framework, retreating from its recent experiment with a more lenient inflation target.
- In 2020, the Fed adopted Flexible Average Inflation Targeting (FAIT), which allowed it to let inflation run above 2% to make up for past periods when it was below target.
- After being "burned" by the subsequent inflation surge, the Fed is now signaling a return to a simpler Flexible Inflation Targeting (FIT) framework, similar to what it used from 2012-2020.
- This reflects a desire to re-establish credibility, but it will be tested as fiscal pressures mount.
Rethinking the Policy Rate: The Case for NGDP Targeting
- Beckworth advocates for an alternative framework: targeting the level of nominal GDP.
- Nominal GDP (NGDP) Targeting focuses on stabilizing the total dollar value of spending in the economy, rather than just inflation.
- He argues this approach is superior because it correctly handles supply shocks. For example, in 2008, an inflation-targeting Fed was hesitant to cut rates because of high oil prices (a supply shock), worsening the recession. An NGDP target would have signaled the need for immediate easing as total spending collapsed.
- For investors, an NGDP target could provide a more stable and predictable policy path, as long-term interest rates tend to track the growth rate of nominal GDP.
The Limits of Forward Guidance and the Fed's Balance Sheet
- The discussion turns to the Fed's communication tools and balance sheet management, highlighting their limitations in the current environment.
- Forward Guidance: Tools like the "dot plot" are conditional forecasts but are often misinterpreted by markets as unconditional promises. This misinterpretation contributed to the surprise and volatility when the Fed rapidly hiked rates, catching institutions like Silicon Valley Bank off guard.
- Balance Sheet: Governor Waller has proposed moving the Fed's portfolio toward shorter-duration assets (T-bills) to match its liabilities (overnight reserves). This would reduce the Fed's interest rate risk.
- However, unwinding its current long-duration holdings without disrupting markets is a major challenge. This entire conversation may be moot if fiscal dominance forces the Fed to expand its balance sheet again.
The Political Push to End Interest on Reserves
- A key debate in Washington is whether to eliminate the interest the Fed pays to banks on their reserves.
- Interest on Reserves (IOR) is the Fed's primary tool for controlling its policy rate in the current "ample reserves" system.
- Politicians like Ted Cruz and Rand Paul argue that eliminating IOR would save the government money that is currently being paid to "big banks."
- Beckworth debunks this, explaining it offers no "free lunch." If reserves paid zero, banks would simply shift their holdings to Treasury bills. The government would still end up paying a similar interest rate, just through the Treasury instead of the Fed.
Conclusion
The U.S. is in Stage 2 of fiscal dominance, where government debt is actively shaping monetary policy and financial regulation. For Crypto AI investors, this means monitoring how fiscal pressures drive policies on digital assets like stablecoins and anticipating increased market volatility as the Fed's independence is tested.
