Second of two parts.
It is 2026. A new Fed chief has been installed after committing to follow the president’s demands to cut interest rates and keep them low. The Fed’s first act is a 1 percent cut in interest rates. How will the markets react?
If history is any guide, the stock market would roar. Bond yields across the board might plummet. The economy would catch on fire. Home prices in the real estate market could climb as buyers take advantage of falling mortgage rates. It would be a time to break out the champagne because good times are here again.
However, history may not be an accurate reference point. In the above scenario, we would be living in a macroeconomic environment in which the independence of the Fed will have taken a back seat to our high public debt and deficits. Those twin issues would now be the new Fed’s focal point dictating and constraining America’s monetary policy.
The U.S. would have entered a regime where the central bank’s usual objective of controlling inflation and sustaining employment becomes secondary to the U.S. Treasury’s budget financing needs. To accommodate the government’s borrowing, the Fed would be expected to keep interest rates low, and if necessary, buy government debt (quantitative easing) on an ongoing basis.
Welcome to a state of fiscal dominance. We have had our first taste of this condition when former U.S. Treasury Secretary Janet Yellen increased from 25 percent to 50 percent the amount of short- versus long-dated debt the government issued. While yields on Treasury bills and notes fell, long-dated securities ( the 10-, 20- and 30-year bond yields) rose. Why?
Holders of longer-term bonds were not so quick to buy more in the face of the government’s new tactics. As a result, the Fed reversed its quantitative tightening program and bought back more Treasury bonds and sold less. At the same time, the U.S. economy began to decelerate in both real and nominal terms.
The same thing happened in Japan in the first decade of this century. The Japanese central bank began buying Japanese Government Bonds (JGB). The Bank of Japan is now the largest holder of the country’s national debt worth $4.3 billion. Under fiscal dominance, it is not hard to imagine a future where the U.S. Federal Reserve Bank becomes a bigger and bigger buyer of our debt.
To be sure, keeping interest rates low in an economy as large as ours would put a lot of pressure on the financial system. It would require the central bank to inject massive liquidity (print money) in order to keep buying up T-bills and notes while utilizing quantitative easing to buy Treasuries on the long end. In a situation like that, there would have to be fallout. In past episodes of fiscal dominance (mostly in emerging markets), it was the currency that fell victim to these government policies.
Consider that the dollar year to date, is down around 10 percent. The combination of Donald Trump’s trade policies, inflation, America’s increasing deficit and debt, and the administration’s disruption of American foreign policy has created alarm and a building distrust from friend and foe alike. These set of circumstances have conspired to pressure the dollar’s downward spiral.
Notice too that neither Trump nor his cabinet have uttered a word about the dollar’s decline. That may be because in general, taken alone, currency declines can be good for the value of real assets. However, an imploding currency, especially if we are talking about the world’s reserve currency, would create an enormous flight of capital by foreigners who hold trillions of dollars in U.S. bonds and stocks. That has not happened yet.
If Trump were to manage a fiscal dominant regime in the coming year, I expect the decline in the dollar would continue. That would hurt export-driven economies like Europe, Japan and China. At some point they would be forced to cut their interest rates and drive down the worth of their currency to protect their own exports. Economists would refer to this as a competitive devaluation. In a world where all currencies were declining, investors actively would be looking for somewhere to preserve their assets.
We are already witnessing that trend in action. Higher prices for gold, silver, and other precious metals, as well as the recent price gains in crypto currencies are no accident. It appears to me that investors worldwide already are anticipating further declines in the U.S. currency and are hedging their bets and exposure to the U.S. dollar.
As for the stock market, there will be winners and losers. Real estate, commodity, precious metals and oil stocks should do well. Anything that tracks the rate of inflation higher would be attractive investments. Exporters could benefit from a lower dollar while those that depend on exports will not.
Rate sensitive sectors like technology, consumer discretionary, financial and growth stocks might not do as well. Given the greater role government would play in the economy, infrastructure, defense and health care could do better. Foreign stocks, especially real asset-rich emerging markets, could outperform domestic equity as well.
Business The Federal Reserve’s role in today’s populism By Bill Schmick 2 min to read
The question many readers might ask is will the country go along with this policy change? I suspect it would, given the era of populism we find ourselves in. In my May 2024 column, “The Federal Reserve’s role in today’s populism,” I argued that the U.S. central bank’s monetary policy is and has been a ‘top-down approach’ where lowering interest rates primarily benefited the wealthiest segment of the population and the largest companies within it.
It was they who could borrow the most but needed it the least, that benefited, while Americans at the other end of the scale could borrow not at all. An independent Fed is a Fed that inadvertently fostered and increased income inequality among Americans in my opinion. Given that, I am guessing that a different approach to monetary policy might be greeted with open arms among a large segment of the population.
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