Inflation Risk in a World of Fiscal Dominance

The Fed should refrain from caving to political pressures

There is a lot of talk about the inflationary effects of tariffs on the U.S. economy. As my colleague Veronique de Rugy points out, trade barriers do lead to one-time cost increases, but the higher-trend inflation we’re seeing is broader and more persistent:

“Inflation is accelerating even in areas untouched by trade policy. The stickiness of service-sector prices, combined with the lagged way housing costs show up in the Consumer Price Index, demonstrates that inflationary momentum comes from more than just tariff pass-throughs. Tariffs add fuel, but they are not the spark.”

The underlying drivers of higher-trend inflation are not supply restraints, tariffs, or misguided monetary policy. Rather, the main driver is the lack of a credible fiscal framework to stabilize public debt.

Government policy decisions have only made the risks of higher-trend inflation worse. Since raising the debt ceiling under the One Big Beautiful Bill Act (OBBBA), we have seen public debt increase by over $1 trillion.

While monetary tightening is one piece of the inflation-reducing puzzle, it cannot achieve low and stable inflation by itself. In the absence of fiscal consolidation, monetary policy is ineffective at best and counterproductive at worst.

History demonstrates that stabilizing inflation requires both monetary tightening and fiscal tightening. The heightened inflation rates of the 1960s and 1970s stemmed from the Federal Reserve’s lack of independence from the government’s spending priorities. Federal Reserve Chair Aurthur Burns was under pressure from both the Johnson and Nixon administrations to keep interest rates low.

Chair Burns openly acknowledged how these political priorities limited the Fed’s ability to quell inflation:

“The persistent inflation that plagues the industrial democracies will not be vanquished — or even substantially curbed — until new currents of thought create a political environment in which the difficult adjustments required to end inflation can be undertaken.”

In the early 1980s, what changed was that the anti-inflation stance of the new Fed Chair, Paul Volcker, was backed both in rhetoric and through policy actions by the Reagan administration. Reagan took a strong stance against inflation while also advocating for a smaller government (raising expectations of fiscal consolidation). He also refused to criticize the Fed chair publicly.

While the 1981 tax cuts led to an immediate fiscal deficit, they were quickly followed by measures aimed at broadening the tax base and narrowing the budget deficit. These changes included the Tax Equity and Fiscal Responsibility Act of 1982, the Social Security Amendments of 1983, and the Deficit Reduction Act of 1984.

Today’s situation more closely resembles the fiscal dominance of the 1960s and 1970s. This resemblance suggests that we are not out of the woods yet: The possibility of continued inflation well above target levels has not yet passed.

The president has repeatedly criticized the Fed chairman for not cutting interest rates: President Trump has suggested that he will replace Chair Powell with a yes man who would cut rates at the president’s demand.

Even so, while the Federal Reserve can manipulate short-term interest rates by reducing the federal funds rate, longer-term yields are determined by broader macroeconomic factors, inflation expectations, and the natural rate of interest. The Fed could potentially suppress longer-term yields by monetizing newly issued debt, but this would signal that deficits will be financed through money creation rather than fiscal action, thereby exacerbating inflation.

Another inflationary risk is financial repression, which occurs when the government attempts to artificially lower interest rates by intervening in markets to divert capital to the purchase of Treasury securities. To some extent, policies consistent with financial repression are already being proposed or implemented, such as the easing of bank leverage rules (which incentivizes banks to hold more Treasuries) or the passing of the GENIUS Act (aimed at boosting demand for short-term Treasuries).

A million miles from the inflation-crushing policies of the early 1980s, we now find ourselves in a fiscal dominance scenario. Under fiscal dominance, the central bank is forced to accommodate deficits, and this means that inflation expectations — not Fed policies — anchor long-term rates. Unfortunately, history and economic theory suggest that fiscal dominance comes with serious upside inflationary risks.

If the Federal Reserve caves to the pressures of the fiscal authority and begins lowering policy rates while inflationary pressures remain elevated, it may be choosing to tolerate higher inflation in order to reduce the financing costs of out-of-control government spending.

In other words, if Congress and the president remain unwilling or unable to commit to deficit-reduction measures, whether through spending restraint or tax base broadening, the burden of adjustment falls on the price level. Households and investors, recognizing that debt will be inflated away rather than repaid, demand higher inflation expectations, which in turn push trend inflation upward.

Moreover, absent fiscal action, the Fed finds itself in a precarious situation. Cutting rates risks fueling inflation but raising rates could further exacerbate it. This is because higher interest rates increase debt-servicing costs and worsen fiscal imbalances, thereby raising inflation expectations.

Stabilizing inflation requires more than interest-rate hikes. It requires a credible fiscal framework that reassures investors the government will generate sufficient surpluses over time to stabilize debt. Without that commitment, monetary tightening alone is insufficient and at times counterproductive.

Put differently: It is not tariffs, nor even the timing of rate cuts, that will decide whether inflation returns to target. It is whether U.S. fiscal policy signals a credible plan to stabilize the debt. Absent fiscal consolidation, the U.S. risks repeating the mistakes of the 1970s: inflation sustained not by tariffs or bad luck, but by an unwillingness to face the arithmetic of debt.