The Federal Reserve’s Actions May Now Be Fueling Inflation
While markets today are focused on the Federal Reserve’s widely expected 25-basis-point interest rate cut, few have been paying attention to what is, perhaps, the more consequential move: Last week the Fed ended its policy of quantitative tightening (QT), or balance sheet reduction. The Fed held $2.1 trillion in Treasurys in 2019, but after it monetized most of the newly issued stimulus debt in 2020 and 2021, its Treasury holdings peaked at almost $5.8 trillion in 2022. The balance sheet has now settled at around $4.2 trillion—twice as much as it was in 2019.
Importantly, every time QT has come to an end, it has been followed by renewed balance sheet expansion, often within months. This raises a core issue: Inflation is ultimately a fiscal phenomenon.
The price level must adjust so that the real value of outstanding government debt equals the present value of expected primary surpluses. When policymakers fail to consolidate the nation’s fiscal imbalances, the adjustment takes the form of higher prices.
Ending QT Locks in Fiscal Costs
By ending QT, the Fed has effectively committed to maintaining a large stock of long-duration, low-yield Treasury securities on its balance sheet. Although the Fed has recently returned to positive net income, it still carries a substantial deferred asset from past operating losses. This means the Fed will not remit earnings to the Treasury for many years, keeping the government’s fiscal position weaker than it would otherwise be.
Beyond fiscal costs, every time the Fed has ended a cycle of QT in recent history, this action has been followed by balance sheet expansion. Given that the Fed has now ended its latest cycle of QT, it is highly likely that the balance sheet will start growing in 2026, or shortly thereafter.
This consequence reinforces the belief that the nominal stock of government liabilities will continue to rise without any credible fiscal offset. Given that expectation, higher inflation today is the rational response.
Cutting Rates in an Inflationary Environment
For six consecutive months, inflation has been on an unbroken upward trend, from 2.3% in April to 3% in September. Yet the Fed has been engaged in an expansionary cycle, cutting the federal funds rates by 170 basis points over the past 15 months.
Cutting overnight lending rates in an environment of rising inflation is not just a policy mistake, but a strong fiscal signal. Lower nominal and real rates increase the present value of outstanding debt, absent improvements in the fiscal outlook. If those fiscal improvements (future surpluses) never materialize, then the only adjustment mechanism left is higher inflation.
Fed rate cuts in an inflationary period look less like monetary dominance and more like a government trying to reduce real debt burdens through the price level.
If Congress Doesn’t Stabilize the Debt, Inflation Will
Once you combine (1) a public debt ratio of over 100%, (2) rising inflation, (3) cuts in interest rates, and (4) a Fed balance sheet that is still above $4 trillion with years of embedded losses, you get a fiscal stance that is increasingly unsustainable without help from inflation. Markets internalize the fact that the Fed’s liabilities are government liabilities, and the Fed’s losses are fiscal losses.
If Congress does not or will not generate future surpluses large enough to stabilize debt, then inflation must become the stabilizer—ultimately to the detriment of American consumers.