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As the 2024 election looms, much of the media focuses on the candidates' policy debates. But regardless of who wins, evidence shows that the path of the U.S. deficit will continue rising in the decades to come.

The question won’t be: “who will get the budget under control?” but rather, “who will the deficit rise less under?”

Thus, beyond the election drama, there’s a bigger issue simmering in the background - one that could shape the U.S. economy for decades to come.

We’re talking about the rise of fiscal dominance.

Fiscal dominance occurs when the government’s heavy borrowing and spending (via deficits) overpowers the central bank’s ability to manage inflation through monetary policy.

• In simpler terms, it’s a power struggle where the Treasury’s spending habits for political purposes can handcuff the Federal Reserve’s attempts to manage inflation and employment.

In the years ahead, this tug-of-war between the Federal Reserve and the Treasury will intensify, with rising government deficits threatening to undermine the Fed’s ability to steer the economy and keep inflation subdued.

So, what does this mean for you as someone who’s simply trying to make sense of where the economy is headed? Let’s break it down.

Understanding Fiscal Dominance: Treasury vs. Fed

The Federal Reserve and the Treasury each manage liquidity in the economy but with different tools and timeframes.

For instance, the Fed uses cyclical measures like interest rate adjustments and quantitative programs (such as buying and selling bonds) to manage inflation and economic activity in the short term, either stimulating or cooling the economy depending on its needs.

In contrast to the Federal Reserve’s short-term, cyclical actions, the U.S. Treasury operates on a structural level, using long-term fiscal strategies such as deficit spending, taxation, and funding for social programs or infrastructure projects. These actions influence the economy over a longer time horizon. For instance, if the government spends $110 but only collects $100, the resulting $10 deficit means more money is injected into the economy, thereby increasing overall liquidity and demand.

• Example: While the Fed raises interest rates to cool inflation, the Treasury might inject money through large deficit spending. Think of the COVID-19 stimulus payments. The Treasury pumped a massive amount of cash directly into the economy, flooding it with relief. Inflation then surged to a multi-decade decade high¹, which required the Fed to raise rates to try and slow things down. One side tightened, the other loosened.

This push-pull dynamic between the two can result in contradictory goals – creating an unstable economic system.

Fed’s Dual Mandate vs. Political Agendas

Furthermore, it’s important to note the Federal Reserve’s “dual mandate” since 1977² - aimed to control inflation (price stability) and maximize employment.

This dual mandate dictates how the Fed sets monetary policy – by reducing interest rates if inflation falls too low (below 2%) or if unemployment rises too high. And vice versa.

But this becomes difficult when political agendas drive fiscal policy in the opposite direction. Politicians often push for large-scale fiscal measures which may conflict with the Fed’s inflation-control goals.

This misalignment, where fiscal policy works against the Fed’s monetary goals, can weaken the Fed’s ability to meet its mandate, resulting in a scenario of fiscal dominance.

How Rising Deficits Undermine the Fed’s Control

Now, historically both the Fed and the Treasury would work in unison – a recession would mean the Fed would ease policy, and the Treasury would run larger deficits to stimulate growth.

But now – in the era of Fiscal Dominance - the trend of larger fiscal deficits has become a defining feature of the U.S. economy – and creates a problem for the Fed.

For instance, following the Great Recession in 2008, U.S. federal debt – held by the public – as a percentage of GDP sharply increased, rising from around 70% of GDP to 100% by 2020, largely driven by economic stimulus measures and recovery efforts. The COVID-19 pandemic in 2020 triggered another surge in government spending, maintaining the debt level at around 100% of GDP.

• Please note that as of the second quarter of 2024, the Federal Reserve also holds approximately 16.6% of U.S. federal debt relative to GDP³. This percentage reflects the Federal Reserve's buying of U.S. Treasury securities as part of its efforts to manage interest rates and the money supply.
  
  Combined, the total U.S. federal debt stands at approximately 120% of GDP – which means the country owes 20% more than the total value of all goods and services it produces in a year.

More troubling is that projections show federal debt continuing to rise, exceeding the previous record high of 106% (from World War 2) around 2028 and reaching 172% of GDP by 2054, driven by long-term structural deficits and rising interest costs.

Highlighting this, according to the CBO, Net Interest Outlays - the costs the government incurs to pay interest on its accumulated debt – is becoming a primary driver to the overall deficit, meaning that old debt is causing new debt issues⁴.

Source: "The Budget and Economic Outlook: 2024 to 2034," Congressional Budget office, February 2024

This ongoing upward trend implies significant fiscal pressures in the coming decades – especially as interest payments begin compounding on an ever-rising national debt.

Meanwhile, the more the Treasury borrows, the more it adds to the national debt. This borrowing increases overall liquidity in the economy and sustains high levels of demand, putting upward pressure on prices (causing inflation).

The Federal Reserve’s ability to mitigate this is constrained by the sheer scale of government borrowing, which forces it into a position where traditional monetary tools become less effective.

The Rise of Fiscal Dominance: How Treasury Overpowers the Fed

As mentioned previously, fiscal dominance occurs when government spending and borrowing take precedence over the central bank's ability to execute effective monetary policy.

In a fiscally dominant environment, the Federal Reserve’s actions - like hiking interest rates - are less impactful because fiscal policies continue to inject liquidity through bigger deficits. This creates a scenario where inflation remains elevated for longer periods, as the Fed’s efforts are undercut by fiscal expansion.

Historically, fiscal dominance has surfaced during times of high national debt and significant government intervention in the economy.

• A prime example is the post-World War II period, when the U.S. government issued substantial debt to fund reconstruction efforts, forcing the Fed to accommodate fiscal policy by keeping interest rates low.

Today, we are seeing a similar situation. With government spending commitments on social programs, healthcare, and defense growing, the Federal Reserve faces increasing pressure to accommodate these expenditures and keep interest rates lower to service the national debt.

But the risk is that the Fed could lose its autonomy, needing to prioritize government debt financing over inflation control - leading to longer periods of high inflation, which undermines the Fed’s credibility.

For example, when the Fed raises interest rates to bring down inflation, it makes borrowing more expensive for everyone, including the U.S. government. And since the government must borrow money to pay off its maturing debt, higher interest rates mean it can't refinance at lower rates like before. This increases the cost of paying back the debt, straining the federal budget and making it harder for the Fed to keep using rate hikes to control inflation.

Thus, Some Key Risks of Fiscal Dominance Are:

• Prolonged Inflation: Fiscal expansion may outpace the Fed's ability to control inflation, resulting in persistently high prices.
• Economic Volatility: A weakened Fed may lead to market instability, higher interest rates, and slower growth.
• Recession Risk: Sustained high interest rates could trigger a recession, exacerbating fiscal and economic pressures.

Potential Solutions to the Fiscal-Monetary Conflict

As fiscal dominance rises, the economy faces a greater risk of prolonged inflationary periods.

If inflation stays elevated, the Federal Reserve may be forced to raise rates higher or for a longer period than expected, which could slow economic growth and increase the likelihood of a recession. Markets may react negatively to the loss of confidence in the Fed’s ability to manage inflation, leading to more volatility and higher long-term interest rates.

On the other hand, the U.S. could also see a scenario where coordination between fiscal and monetary policy becomes necessary. This would require politicians to make tough decisions about reducing deficits and managing public debt - a difficult (and unlikely) ask in an environment where political pressures often favor short-term solutions over long-term fiscal discipline.

Conclusion: The Growing Conflict Between Fiscal and Monetary Policy

The growing influence of fiscal dominance raises significant concerns for the Federal Reserve’s ability to manage the economy.

As government deficits and public debt continue to rise, the Fed's traditional tools are becoming less effective, and its ability to control inflation is being undermined by fiscal expansion.

Moving forward, policymakers must address the growing conflict between fiscal and monetary policy to ensure economic stability in the long run. But that doesn’t seem likely in an era of structural deficits.

Sources:

1. Economic Crossroads: What Lies Ahead for Consumers as Excess Savings Evaporates? | Dunham
2. The Federal Reserve's "Dual Mandate": The Evolution of an Idea | Richmond Fed
3. The Budget and Economic Outlook: 2024 to 2034 | Congressional Budget Office (cbo.gov)

Disclosures:

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Information contained in the materials included is believed to be from reliable sources, but no representations or guarantees are made as to the accuracy or completeness of information. This document is provided for information purposes only and should not be considered as investment advice.