Investors beware: Fiscal dominance and financial repression ahead

The Hill

4 days ago

A cautious Federal Reserve kept policy rates unchanged during the first half of 2025. It was trying to ascertain whether the Trump administration's protectionist measures would result in a one-time price level shift, or whether the radical attempts to reshape global trading patterns might generate persistently elevated inflationary pressures.
But the fact that policy rates have not budged since last December has infuriated President Trump. He has repeatedly castigated U.S. monetary authorities for their reluctance to cut rates. Believing that the Fed has fallen behind the curve, President Trump has taken to refer to the Fed chair derisively as 'Too Late' Jerome Powell.
Amidst widespread concerns surrounding U.S. fiscal sustainability, President Trump recently suggested that the Federal Reserve should substantially cut policy rates to help lower the mounting interest rate cost associated with servicing the massive government debt. Trump has gone so far as to state that he would pick someone favoring rate cuts to be the next chair of the Fed.
Independent analysts forecast U.S. debt-to-GDP ratio to spiral upwards following the passage of the 'big, beautiful bill.' Furthermore, budget deficits are expected to continue to exceed 6 percent of GDP over the coming decade (levels previously attained only during crisis periods). These developments, in conjunction with political pressure on the Fed to lower interest rates, raise the specter of fiscal dominance of monetary policy.
'Fiscal dominance' refers to a scenario in which a government's fiscal needs (reducing an unsustainably large debt burden or persistent deficit) start to constrain or even dictate the actions of the central bank, compromising its ability to conduct independent monetary policy. Economic theory and history have shown that fiscal dominance of monetary policy often leads to elevated inflation levels.
'Financial repression' refers to policies aimed at artificially keeping interest rates low to help governments deleverage gradually over time. Economists have highlighted the crucial role that financial repression, in combination with inflation, played in reducing the post-World War II debt overhang. Controlled interest rates (via explicit or indirect caps on interest rates), capital controls and other financially repressive measures were utilized by the U.S. and other advanced economies in the aftermath of World War II.
Several measures currently on the anvil to encourage greater private sector purchases of Treasurys are relatively modest in scope. For instance, the proposed easing of the Supplementary Leverage Ratio requirements (a move expected to boost banks' holdings of Treasurys without violating leverage rules) and the passage of the so-called GENIUS Act (which is expected to encourage the use of stablecoins and thus boost demand for short-dated Treasury bills) are aimed at juicing the demand side of the Treasury market.
Looking ahead, more dramatic measures may be necessary to ease the debt burden. In recent years, there has been a greater reliance on short-dated Treasury bills to finance the ballooning deficits and roll over maturing debt. This has reduced the average duration of U.S. government debt. If the Fed bows to political pressure and lowers policy rates (and thus effectively reduces Treasury bill rates), it will temporarily aid Trump administration efforts to ease the interest rate burden.
The majority of the outstanding debt, however, is still in the form of longer-dated securities (primarily Treasury notes and bonds). The Fed effectively controls short-term interest rates and it can also influence expected future short-term rates via forward guidance (public communication by monetary authorities of the anticipated direction of future short-term policy rates). However, long-horizon interest rate expectations and term premia are not directly controlled by the central bank.
Macroeconomic fundamentals, such as long-run inflation expectations and the natural rate of interest, are crucial determinants of long-term interest rate expectations. Furthermore, term premia are likely to be affected by the extent of inflation uncertainty and underlying shifts in the Treasury market supply-demand dynamics (such as changes in overseas/safe-haven demand).
As the debt-to-GDP ratio rises to dangerous levels, and as doubts surrounding the dollar's reserve status emerge, the risk of a term premium spike is significant. If the demand for long-dated Treasury securities from abroad suddenly collapses, and if there is a concomitant flight from the long-end of the yield curve by domestic investors, then pressure will inevitably mount on the Fed to go back to quantitative easing — that is, using reserves newly created by the central bank to acquire long-dated securities. Under current circumstances, this would be tantamount to monetizing portions of the U.S. debt.
If interest rates are kept artificially low even as inflationary pressures remain elevated, there is a real risk that investors and savers will face the brunt of the adjustment costs necessary to achieve fiscal sustainability. Given America's status as a rich, mature economy with an aging population, it is unlikely that, even with an AI revolution, we can grow our way of the spiraling debt trap. Absent effective policies to lower budget deficits and retain Treasurys' global allure, bond investors should be prepared for fiscal dominance and financial repression.
Vivekanand Jayakumar, Ph.D., is an associate professor of economics at the University of Tampa.