Promises, promises

Budget deficits, Fed independence and the road to financial repression

You made me promises, promises
You knew you'd never keep
Promises, promises
Why do I believe
All of your promises
You knew you'd never keep
Promises, promises
Why do I believe?

— From the musical Promises, Promises, lyrics by Hal David

I don’t know about you, but I regularly receive in my social media in-box friendly reminders from the White House about the “promises made [and] promises kept” by President Trump, like the one pictured above. Which is fair enough, as the President has in fact kept many of the promises he made on the campaign trail, for example his promise to increase tariffs, to make permanent his ‘temporary’ 2017 tax cuts, to increase spending on defense and immigration enforcement, to eliminate federal income taxes on overtime, tips and social security. And he is well on his way to making America the “crypto capital of the world”.

Yes, there have been other promises which the President has not yet fulfilled, like ending the war in Ukraine (“on day one, with a single phone call”), cutting energy prices by 50% (“in the first 180 days”) and drug prices by 1500% (???), paying down the federal debt with a “massive” DOGE dividend, raising “trillions of dollars” from his new tariffs, and of course releasing the Epstein files. But let’s not quibble. The Trump administration has by all accounts been incredibly active (even hyperactive) in its first six months, perhaps the most activist opening to any presidential administration since FDR in 1933.

And now President Trump is promising—threatening really—to replace Fed Chair Powell with someone more inclined to do his bidding in the matter of setting interest rates. The press has duly reported the latest verbal assaults by the President on Fed Chair Powell, most recently in conjunction with the President’s ludicrous ‘tour’ of the Fed HQ construction site. And numerous talking heads (myself included) have bemoaned the President’s assault on “Fed independence”, and the sheer idiocy of his calls for a 300bp cut to Fed rates, often without much of an explanation on what this means or why we should be concerned.

At one level, what President Trump is now doing does not seem all that remarkable. He is simply calling on the Fed to cut rates, which some independent observers also believe would be appropriate. But those who believe this description of the President’s actions are deluding themselves, perhaps willingly. No other president since Harry Truman in 1951 has come even close to doing what President Trump is now doing, strong-arming the Fed into slashing interest rates for the purpose of providing cheap financing to the federal government.

This is a big deal, regardless of what the President’s supporters might like to believe.

Harry Truman tried to do this in 1951, as the US entered the Korean conflict, but he was attempting to finance a war, not cover up the fiscal consequences of his own administration’s policy mistakes. His actions were also consistent with almost a decade of precedent established during World War II (and before that in WWI), when the Fed directly supported the debt-financed war effort with artificially pegged (low) interest rates, a decision taken at the direction of Treasury but with broad political support, including from Congress.

To my knowledge, however, the United States is not currently at war (other than with ourselves). And the Fed’s practice of holding rates low to support growing fiscal deficits (in war time) ended with the Treasury-Fed accord of 1951, which began our tradition of ‘Fed independence’ in the operation of monetary policy, now under attack from President Trump. And more importantly, Congress in 1977 amended the Federal Reserve Act to make clear that the monetary policy mission of the Fed would henceforth be to promote full employment and stable prices, not to keep rates low for the purpose of financing federal deficits.

But this of course is exactly what the Trump administration is now attempting to do: force the Fed to cut rates in order to lower the cost of financing the Trump administration’s growing fiscal deficits. And it is ironically doing so shortly after passage of the President’s Big Beautiful Bill, which will add an estimated $5-7 trillion to federal deficits over the coming decade.

And these efforts go well beyond President Trump’s ill-tempered, and likely counter-productive, attempts to fire Chair Powell. In fact, the Trump administration is already working hard behind the scenes to find creative new ways to stuff increasing amounts of low-cost government debt into the portfolios of financial institutions, including of course the Fed itself.

The first step has been to pressure the Fed to cut nominal interest rates, which we can expect at some point to morph into calls for the Fed to buy more government debt (or to sell less of it). The next step will be for Treasury to increase its issuance of shorter-term securities (T-bills) in anticipation of future Fed rate cuts and a likely increase in longer-term interest rates (or term premiums) in response to the Fed’s politically motivated rate cuts. Proposed regulatory changes will encourage banks to hold larger amounts of UST debt than they currently do, notwithstanding the banks’ recent near-death experience with rising rates and collapsing bond prices in the wake of covid.

This will be followed by calls for the Fed to stop paying interest on bank reserves, saving the federal government a large amount of money (currently) but also making it harder for the Fed to manage monetary policy and forcing the banks to look elsewhere for even low amounts of yield (eg on Treasuries). The recently passed stablecoin legislation promoted by the Trump administration has been structured explicitly to increase the demand for UST debt, which Treasury Secretary Bessent has said will add several trillion dollars of incremental demand for T-bills over the coming years.

And even the Trump administration’s goal of making America the “crypto capital of the world” fits nicely into this picture, as the value of bitcoin and other crypto assets (as well as the President’s own personal portfolio) will likely sky-rocket in this environment of increasing federal deficits, artificially low interest rates and a falling dollar, all of which the Trump administration seems to be promoting.

President Trump may well believe that he must take personal control of monetary policy in order to force the Fed to cut rates, after replacing Chair Powell and perhaps other members of the Fed Board and relegating the Fed to what will in essence become a subordinate unit of the Treasury Department. Other cooler heads in his administration know better, however, and they understand that there is no realistic chance for the President to do what he would like to do in the way he would like to do it. But they still believe they can force the Fed to do their bidding, while keeping their own hands clean, a task which would admittedly be easier to accomplish if the President would just stop tweeting.

Over the coming years, it is quite likely that uncontrolled federal deficits will have become so large, and political gridlock in Washington so entrenched, that the nominally still-independent Fed will have little choice but to shift gears from its mission of controlling inflation to one of promoting inflation, without the necessity of undue pressure from the White House.

Rising fiscal deficits will force the Fed to inflate away some of the massive growth in federal debt, reducing the apparent cost of our fiscal profligacy. There will no doubt be times when this isn’t working, and the bond market is simply not buying enough Treasury debt, or isn’t willing to buy it at such low real (inflation-adjusted) interest rates. And so the Fed may find that it has no choice other than to step in and use its balance sheet to bail out the federal government, monetizing the unwanted Treasury debt with increasing amounts of (zero-interest) bank reserves.

And when this happens, we should not blame the Fed, or for that matter President Trump, who is as much a symptom as he is a cause of our current difficulties. We will have gotten to this point because of the fiscal choices which we and our elected representatives in Washington have made over the past twenty-five or even sixty years.

Over these many years, we have elected to office politicians who have been more than happy to make us promises they knew they would not keep, in the form of unfunded commitments to raise federal spending with no real intention of ever raising the taxes necessary to pay for it all. And we all believed these promises, or convinced ourselves that we believed them, if only to reduce our own guilt about leaving future generations to deal with our massive unpaid bills. And based on what is now happening in DC, it seems that nothing has really changed.

Promises, promises indeed.