Messing With the Fed

2025 07 13

Quico Toro at uncommentable, un restackable “Persuasion” has a timely warning: Messing With the Fed Is Playing With Fire - by Quico Toro

There are lots of reasons not to mess with the Fed. The fact that the dollar is the World’s reserve currency is nice but not the main reason. The dollar’s role as reserve currency, per se, is not as important as the fact that The US dollar has been a safe place for foreigners to invest short term. (Reserve holding is just one reason to invest short term in the US dollar.) And in terms of income generation, being a safe place for foreigners’ short term investments is not as important as the role of US financial institutions in managing the world’s payment system. These are downstream of more than good monetary policy.

See The, Privilege or Burden?

And Toto knows this:

American debt is only accepted as risk free because investors around the world believe that if the U.S. government runs up too much of it, that government won’t be able to just order the Fed to print up extra dollars to make up the difference—that way lies hyperinflation. But when the U.S. president straight-up announces that the Fed will be run by governors willing to keep short-term interest rates artificially low to suit his political interests, that assumption starts to look shaky. A Fed that can’t say “no” to the White House is a Fed that can’t credibly defend the value of the dollar.

And there’s just no reason to think the rest of the world will want to denominate its savings in a currency Donald Trump—or any U.S. president—can debase with a tweet.

But the victims of macroeconomic nonsense—from Venezuela and Argentina to Turkey and Zimbabwe—know that this sort of monetary policy skullduggery isn’t quite enough to do your country in. Real trouble comes when fiscal policy—the government’s taxing, spending and borrowing decisions—takes a leave-of-absence from common sense. Messing with the Fed is bad. Messing with the Fed while you’re on an almighty spending and borrowing spree is much, much worse.

And yet that’s exactly what’s happening. Trump’s “One Big Beautiful Bill” includes $3 trillion worth of deficit spending, and it’s estimated that it will push the country’s debt-to-GDP ratio to a shocking 130% by 2034—much higher even than it was at the end of World War II, when it topped out at 106%. Which means the United States is going to need to borrow a lot more.

Big deficits + cheap money are the textbook recipe for out-of-control inflation. That’s no way to run a reserve currency.

True enough, but more important, its no way to run a prosperous growing economy. Large deficits, the sign of borrowing from investors to transfer to consumers, sap growth however well the Fed controls inflation.

Stock markets, high on their tax-breaks and gorging on their TACOs,¹ refuse to take it all quite seriously. I watch it all and pinch myself, wondering if I’m the last sane one around. The United States is now very much pledging to go on a world-historic borrowing binge while it puts its monetary policy in the hands of political hacks. That cannot end well.

Look, I can’t tell you when and how exactly this all comes to a head. It could take decades or years, or it might be months. Does a bond rout happen quickly or gradually? Or does the rush to safety lead investors, paradoxically, back towards the assets causing the instability in the first place, reasoning that bad as they are they’ll be less unstable than the rest? Does capital instead rush headlong to Shanghai, and the world start to denominate value in yuan? Does it bolt for Frankfurt? Or London? Does it fracture and give way to long-term instability? I have no idea. No one does.

We’ve never really been through a situation like this, where the world’s investors, as a group, lose faith in the soundness of the denominator asset. What comes after the era of U.S. dollar hegemony is anybody’s guess. But if Trump follows through on his promise and picks a lunatic or a stooge (or a lunatic stooge) to run the Fed, markets are liable to panic in ways that have long-lasting effects.

Once macroeconomic stability is gone, it’s hard to get it back. People hate this experience: within a couple of decades, our democracy had collapsed. In the United States, with democracy already under strong pressure, things could happen much more quickly. What gets me is that there are already plenty of eyes on America’s institutional decay—but barely any on the way macroeconomic instability could accelerate it.

Worry more.

And worry more than about the Fed’s decision making. Even the most responsible Fed with an interpretation of its Congressional mandate -- balance “stable prices” with “maximum employment” -- to manage inflation (or NGDP it that is what one thinks is the better target) to maximize real income, is in a three-way bind.

1) Enormous USG fiscal deficits will at some point require higher interest rates to hold to inflation (or NGDP) targets.

2) Yet in the short run the uncertainties of on again/partly off again tariffs and the labor force reductions stemming from deportations are supply. shocks that may require lower interest rates.

3) But such a policy coming at a time when the President is pressuring for lower interest rates could appear to be acquiescing to such pressure and hence would undermine market confidence in the target itself.[1]

Or should I say four-way bind?

The Fed is in the middle of reassessing its multi-year policy regime, the framework withing which it sets the values of its policy instruments to address, for example the three points above. [See Baby and Bathwater Questions]

The current regime, Flexible Average Inflation Targeting (FAIT) very explicitly allows the Fed to aim for temporally above-target inflation rates at least to “make up” for previous periods of below target inflation and more if needed to allow relative prices to adjust to shocks like COVID and (if large enough) tariff increases and deportations. But the flexibility of FIAT also disables the “parental control” that prevents inflating to accommodate irresponsible deficits. If the former risk is diminished compared to the latter, the Fed may see fit to move to a regime in which it more difficult to disable the control.

See:

Cochrane on the Fed,

Fiscal Dominance and Fed Independence, and

Which Target for the Fed

Worry even more!

Image Prompt: Band of travelers confront a three-way fork in the road as the leader looks behind them at a wolf.

[Standard bleg: Although my style is know-it-all-ism, I do not deny that I can be mistaken or overstate my points. I also know there is an amazing range of views and experiences among readers. Bring those to bear by commenting on these posts. Both other readers and I will benefit.]

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[1] Did I say “pressure? Trump is threatening to fire Powell and replace him with a lackey. FT: “Donald Trump Says He will Only Pick Fed Chair Who Cuts Interest Rates