Fed's Independence Faces Fiscal Challenges

Once, the Chair of the Fed was able to freely criticize the irresponsible spending behavior of politicians. In 1990, Alan Greenspan informed Congress that the prerequisite for lowering interest rates was to reduce the deficit. In 1985, Paul Volcker even explicitly urged Congress to cut about $50 billion from the federal budget deficit in exchange for a 'stable' monetary policy. These remarks implied a warning to Congress and the White House: if action was not taken, the risk of an economic recession could loom.

However, the situation has reversed today. The U.S. president is pressuring the Fed over interest rates. Recently, the president stated that the federal funds rate is "at least 3 percentage points higher," insisting that "there is no inflation," and criticized Fed Chairman Jerome Powell for his slow response. This approach is not only aimed at stimulating the economy but also has a deeper purpose of hoping the Fed will finance the deficit.

The president's remarks effectively hinted at a state of "fiscal dominance," where monetary policy is subordinate to government spending demands. He claimed that a 3 percentage point cut in interest rates could save the country $1 trillion each year, marking him as the first U.S. president to explicitly call for fiscal dominance.

The current situation is very different from the past. In the 1980s, the federal debt as a percentage of GDP was only 35%, which seemed manageable. Now, this ratio has climbed to 120%, and the spending on interest payments in the U.S. even exceeds defense spending. This puts the Fed in a dilemma: raising interest rates may further exacerbate fiscal issues rather than resolve them.

The challenges facing the Fed come not only from presidential pressure but also from the growing fiscal demands. Currently, 73% of federal spending is non-discretionary, a significant increase compared to 45% in the 1980s. This means that to reduce the deficit, substantial adjustments must be made to key programs like Social Security and Medicare, which is politically nearly impossible to achieve.

Former U.S. Treasury economist David Beckworth pointed out that when debt interest payments rise and fiscal surpluses are politically unfeasible, sacrifices must be made. These sacrifices may manifest as more debt, more money creation, or a combination of both. He warned that if debt levels are too high and continue to grow, the Fed may be forced to cater to fiscal demands, thereby losing economic independence.

Although Beckworth remains optimistic that it may not come to that, he also acknowledges that the current focus should not be limited to the president's calls for interest rate cuts. More importantly, attention should be paid to the increasing and unavoidable fiscal demands on the Fed.

Now, everyone realizes that the current fiscal policy of the U.S. government is unsustainable. The key question is: who will solve this problem? The challenge facing the Fed is not only to maintain its independence but also to find a balance in a complex economic and political environment to sustain the country's long-term economic health.