Should markets fear fiscal dominance?

Paul Diggle

Hello and welcome to Macro Bytes the economics and politics podcast from Aberdeen. My name is Paul Diggle.

Luke Bartholomew 

And I'm Luke Bartholomew. 

Paul Diggle

Should markets be worried about fiscal dominance, in which monetary policy and inflation-targeting is increasingly subsumed to political ends? Notably to serving a government's fiscal policy agenda? Well, President Trump's increasingly direct political interference in the US Federal Reserve has us and many investors asking precisely that question.So today on the pod we're going to think through the purpose and role of independent monetary policy, trace the genealogy of this moment in which that independence is seemingly under threat, and ask whether markets should fear fiscal dominance. And we're going to hear from a couple of senior bond and multi-asset investors here at Aberdeen during the course of that discussion to get a market perspective from them. But perhaps, Luke, the place to start is just by briefly tracing and outlining Trump's latest moves against the Fed, because it started with a ramping up of rhetorical pressure from Trump, also from Treasury Secretary, Scott Bessent on Fed Chair, Jerome Powell, lobbying him in public to cut rates by 300 basis points or so, down to about 1%. And that has bled at points into more or less explicit threats to remove Powell, ahead of time, or certainly to replace him as Chair once his term is up in May. And maybe to remove him for cause around questions about the costs of the renovation of of the Fed building. It's also seen the Council of Economic Advisers Chair, Stephen Moran, nominated or soon to be nominated onto a vacant FOMC governor position. 

Moran is a close Trump sort of economically. He's a forceful debater. He believes in Trump’s supply side reform agenda. And he thinks that opens up the room for a lot of rate cuts. He may be voting the 50-basis point rate cut straight off the bat if he's in place by the September meeting or afterwards. Most recently then it's escalated further into Trump's apparent or attempted firing of Governor, Lisa Cook, whose term is meant to run until 2038. Trump has seemingly tried to remove her for alleged mortgage fraud, and Cook is fighting back in the court. At this stage it's unclear whether she remains a voting member of the FOMC or not, and quite what the outcome of that case is going to be. 
And finally, Trump seems to be looking into changing how regional Fed presidents are appointed. Perhaps giving state governors more control over those nominations, or perhaps by just using, newly formed majority on the Board of Governors to approve or disapprove the nomination of regional Fed presidents, further increasing the politicisation of the Federal Reserve Open Market Committee.

Luke Bartholomew 

And not to put too fine a point on it Paul but it seems to me that all of those things you described there are just pretty explicit threats to central bank independence, insulation of policymakers from day-to-day political pressure, and what that puts at risk, well, amongst other things, is the inflation target credibility of the central banks, the idea that they will pursue the right kind of policy to deliver on their inflation target. But perhaps even more than that, it is this bedrock institution for the global financial system, the Fed as a representative, independent inflation-targeting central bank, has been this sort of bedrock for almost the entire career for financial market participants as the lender of last resort for the dollar financial system and basically brings and keeps the whole entire financial system ticking over. So in that context, you could argue there's been a fairly limited market reaction to these threats. Perhaps a few security prices have changed, maybe a few correlation structures have adjusted a little bit as we might get into in due course, but it doesn't seem like there's anything like the panic you might think would be appropriate, given the stakes involved here.

Paul Diggle

Well, on that note Luke, let's hear from Max Mcmillan, the Head of Multi-asset Macro investing here at Aberdeen on the shape of the market reaction to these developments. 

Max Macmillan

The general conception is that if there is something worrying about a threat to the institutional framework of the Fed, that's a bad thing and markets should react to it negatively therefore. And I would certainly agree that in equilibrium, if there is going to be more volatility in rates and inflation, you would expect there to be more premia assets and therefore lower fair values. But I would like to highlight that I don't necessarily think, along with the efficient market hypothesis, that markets are always reverting to the equilibrium pricing. In fact, we are more of the philosophy that, you know, through the booms and busts of a business cycle you get self-reinforcing trends, more in line with the thinking, for instance of George Soros, with his reflexivity, whereby once a trend is established, often based on a misconception or an imperfect understanding of the world, the volatility that threatens that trend, you know, if it fails to dislodge the trend, then reasserts the misconception and reinforces the trend. And this happens again and again and again until such a time as prices are so far from the reality, that you get, a reversion - trends reverse and you get the bust cycle. And so I think that as active investors, we prefer to think of the equilibrium as the emergent average around which markets fluctuate. So the reason I say that is because, with Trump's pressure on the Fed, what have we seen? We have seen a weakening dollar, higher equities, steeper rate curves, and higher gold and higher precious metals in general. Now, that has confounded some expectations of those who would have said, well, Trump has done a bad thing, equities should be lower. But if you think of it, in the initial phases, we think this is more likely to be an easy money boom. By maintaining financial conditions too easy for too long, the initial phase is more likely to be enjoyed and celebrated by markets until such a time as it is excessive. And then you do get some form of policy reaction, which not only generates a downturn, but indeed takes you towards, lower equilibrium or lower fair values for, for asset prices. So what I would say about the current market is that, I think the market is doing what it generally does, taking things one step at a time and reacting for now to the pressure from the Fed to keep financial conditions easier. and it would react only later, over time, to the erosion of the independence of the Fed and the negative impact that can have on asset prices. 

Paul Diggle

Okay. Well, the theory goes the central bank independence removes monetary policy from the political cycle, and in so doing increases the credibility of its inflation target or indeed whatever its mandate is, it may lower inflation expectations, and ultimately improve a central bank's chance of achieving its mandate. And a lot of that thinking has its origins in the 1970s inflation experience - the big overshoots of inflation that were initially caused by a series of oil price shocks, but which were arguably made worse by the institutional structure of central banks, which didn't prioritize the nominal inflation anchor in the way that today’s central banks do. And it also, I think, has its roots in advancements in economic theory as well.The idea of time inconsistency problems in which governments may promise low inflation but once wages and prices are set, they then have an incentive to stimulate output via a sort of surprise injection of demand, a surprise increase in inflation. So they have a timing consistency problem. They can't actually credibly commit to low inflation. And again, the theory is that removing that monetary policy lever from government, giving it to independent technocrats solves the time inconsistency problem. And I think as well, there’s just been over the past several decades, a growing societal consensus and sort of legitimacy to the idea of outsourcing monetary policy away from democratically elected officials towards technocrats. 

Luke Bartholomew 

So I think it's actually worth distinguishing in what you were saying there Paul, perhaps two different ideas of central bank independence, especially as it relates to the Fed.
There's one idea of independence, which is the independence of the central bank from fiscal considerations. I mean, it's pretty obvious that central banks potentially have quite large impacts on government borrowing costs. They can, through their various different policy tools, I mean, first in just setting interest rates, often the first thing that moves in financial markets in response to changes in policy interest rates is the bond yield on government bonds across the entire maturity spectrum. So, you know, lower policy interest rates tends to, all else equal, reduce government borrowing costs. And secondly, through the central bank’s balance sheet, they can significantly ease the market constraint on government funding. I mean, at a minimum, they can ensure the ongoing market functioning and liquidity of the government bond market. And then, you know, moving up through the spectrum of other interventions they could go out and buy a lot of those bonds. They can explicitly pin down the yield on longer-maturity bonds, and then ultimately, they could just flat out monetise the government's debt - just print money to cover any government deficits. And at times government's fiscal authorities have relied on those tools as a crucial part of the way in which they fund themselves. I mean, most famously this occurs during war time and during the Second World War in the US the Fed was brought very much under the Treasury's auspices when it came to helping it finance its war financing needs, and the Fed was required to pin down the yields on long-maturity government bonds. And then so said independence from that particular arrangement was actually a celebrated moment in central banking history, known as the Treasury Fed Accord in 1951. And the context for this is that there was rising inflation pressure in the economy as government deficits were very large, as the government was needing to finance the war needs of the Korean War.

And the Fed was able to negotiate with the Treasury such that it would no longer have to had to pin down Treasury yields, and it could set policy in a way that they thought was more appropriate, given those, inflation pressures. So that's one notion of independence. But then there's this other notion of independence, which I think you were talking about a little bit more there, Paul, and that's independence from the political cycle, because, of course, the other thing that central banks can do through their policy is not just impact government funding costs, but impact macroeconomic conditions, growth and inflation in the economy. And it may be that policymakers that are exposed to electoral considerations would want to use those tools to boost the economy before an election, even if this was inappropriate from the perspective of the economy as a whole. This time inconsistency problem, as you described it. And from the Fed's perspective, this is exactly what went wrong during the 1970s, where the Fed under Arthur Burns proved too willing to set policy in a way that pleased then President Richard Nixon, setting policy that was too easy across the course of the decade. And this was in large part responsible for the big pickup in inflation during the 1970s. 

Paul Diggle

Okay. Well, you distinguish there Luke between two different forms of independence, but of course, these are independent inflation-targeting central banks. And the latter is also a critical aspect of many central banks. And I think the story there really is about the end of Bretton Woods and the system of fixed exchange rates, which fell apart in the early 1970s. And with it the jettisoning of a nominal anchor, a fixed exchange rate, to which monetary policy was in part working and the need for a new nominal anchor which then over the subsequent decades, starting with the RBNZ, the central bank in in New Zealand, a broad consensus built that this anchor would be an inflation target. And the apotheosis of the independent inflation-targeting central bank was perhaps the Bundesbank, the central bank of Germany, and then subsequently the ECB, which at least in its initial conception, was made very much in the Bundesbank's image.

Luke Bartholomew

Although perhaps, as ever, the Fed is actually, once again a bit of a special case here, in the sense that it isn't straightforwardly an inflation-targeting central bank in the way of some of those other central banks you describe there Paul. Of course, it has at a minimum, a dual mandate of full employment, maximum employment and also price stability. And for a long time, the Fed actually found itself thinking quite hard about what that language of price stability actually means. Because I guess there's a plain language reading of it, which it just means no inflation whatsoever. You should be targeting 0% inflation. And that in turn led to various technical debates in the 80s and 90s about the correct way of measuring inflation. Maybe there were issues with the so-called ’hedonic’ adjustments to inflation. That meant the headline inflation was actually slightly overstating the true rate of inflation. And so if you targeted 0% on the headline, you'd actually be getting negative inflation at this true hedonic rate. And that was the kind of debate that occupied the Fed for a very long time. And then there were other policymakers that were much happier with a woollier definition of price stability. Just this idea that there's price stability when firms, households, individuals aren't incorporating inflation considerations into their economic plans. It's just not in their mind, really, when they're thinking about making economic decisions, which obviously requires a relatively low level of inflation, the higher inflation is, the more it's going to be an active part of thinking about your future plans. And then there were some concerns amongst Greenspan in particular, that maybe a formal inflation target would limit the central bank's discretion. He much preferred some constructive ambiguity around what it was that the Fed was up to on what it was targeting. But I think consensus is broadly that from the late 90s, the Fed had basically become an implicit inflation-targeting central bank. If you just look at its revealed preferences, that is to say, just how it set policy in response to how the economy was evolving, the kind of things that it was saying and doing, it was quite clear that it did have an inflation target in its mind. And then in January 2012, that became explicit under the Bernanke Fed, the Fed announced that it had a 2% inflation target. Indeed, it had been a huge part of Bernanke's academic career, arguing in favour of an inflation target. So it's perhaps not surprising that he brought this in. And then actually, it's worth saying that strictly speaking, the Fed hasn't been inflation-targeting for the last five years. It's been average inflation-targeting. And that might sound like a small difference, but at least conceptually it's pretty significant.

So the distinguishing feature of an inflation target is just that each year you're targeting the specific target. You know, in some sense that sounds obvious, but what I mean by that is if you miss the target this year, who cares? Because next year it's just a new year. And if you miss it that year, once again as the next year rolls around
it's a new year and you're just targeting the same inflation target year in, year out. Whereas an average inflation target you can't have that bygones be bygones approach because you're trying to average inflation over a longer period of time. So if you miss the inflation target one year then you have to make up for that in the future, because that year of the miss is incorporated in the calculation of the average rate. So you go from just caring about inflation every year to caring about inflation over a longer sequence of years and ensuring that the average over that time is at the level that you want. Now famously, the Fed adopted this framework in 2020 as part of its framework review, and it was very much influenced by the pandemic experience of low inflation. And then most recently, at the latest Jackson Hole conference, the Fed has basically junked this framework and moved back to a much more standard inflation target, partly because I think it thinks that it's harder to communicate this average inflation idea. Maybe it's less appropriate for the way the world is evolving in terms of the kind of shocks hitting the economy and also this sense that maybe it was partly implicated in the inflation overshoot. But anyway, all of which is just to say that, you know, this idea of a straightforward inflation-targeting central bank, the Fed does have a slightly more complicated history around that. 

Paul Diggle 

But nonetheless, as you said earlier Luke, independent inflation-targeting central banks of one form or another have been a central feature of the financial market landscape for the careers, the entire careers of most people currently active in financial markets. And let's hear from Aaron Rock, head of DM rates investing, a government bond investor here at Aberdeen, on how he thinks about the importance of central bank independence for bond markets. 

Aaron Rock 

Without doubt, an independent inflation-targeting central Bank is critically important for financial markets. In terms of bond market investors such as myself, you know specifically, if we think about why that's important there are numerous factors to consider, but I'd probably focus in on a few in particular, namely anchoring credibility, shaping expectations and influencing risk pricing. So firstly, you know, the credibility of monetary policy. So when we look at a particular sovereign bond market, for example, we like to have faith that monetary policy will be set solely to ensure the central bank meets its mandate, which, generally speaking, tend to be based on ensuring low and stable inflation. Why is that important for us? Well, in the past, when central banks were not independent, monetary policy would be dictated in some cases, or at least heavily influenced by political pressure. This led to poor economic outcomes. For example, incumbent governments choosing to ease monetary policy in order to boost growth ahead of an election, potentially at the risk of a spike in inflation further down the line. 

So very, very important is the credibility of that monetary policy setting. Secondly, central bank independence and credibility undoubtedly go hand in hand with the pricing of assets, for example, in sovereign bond markets with independent central banks, you tend to have a lower risk premium attached to those asset valuations. Why is that the case? Well, because the more independent a central bank, the greater the level of faith we as investors have in the predictable nature of that monetary policy setting and hence the stability of inflation. Last but not least then,  inflation expectations - critically important for all markets, in particular fixed income or bond markets. Bond investors are by definition purchasing assets with fixed returns. Therefore, any increase in inflation over that holding period has the potential to erode those returns for us as investors. So any de-anchoring in those inflation expectations can cause volatility in the pricing of those assets. And for the debt issuer, in my case governments, it can mean investors will demand greater compensation to lend to them over longer periods of time. So ensuring those central banks remain independent and credible will allow the government to borrow at cheaper levels. 

Paul Diggle

Okay. Well, I think Luke it's worth tracing out next, the genealogy of this moment that we find ourselves in of mounting threats to central bank independence in general and the independence of the Federal Reserve in particular, because it's more than just a Trump phenomenon. I think it has its roots initially in the post global financial crisis challenge of overly low inflation. You know, a new challenge, an inversion of the 70s experience that was the genesis of inflation-targeting and independence first of all. The challenge was persistently missing the inflation target on the downside and one consequence of that was that central banks experimented with increasingly unconventional loose forms of monetary policy. So zero interest rates in some cases, negative interest rates, of course, large scale asset purchases and quantitative easing. And there was something of a backlash, against some of those measures. Negative interest rates were viewed in some quarters as distortionary- some kind of unnatural aberration and certainly they weren't welcomed by savers. And quantitative easing was in some cases thought of as being distortionary of asset prices, perhaps putting unwelcome upward pressure on asset prices to the benefit of asset holders and the detriment of other actors in the economy. And then alongside that, many central banks arguably engaged in mandate creep as they dipped their toes into goals beyond the inflation mandate - inflation goal. So, for example, environmental policy, has and in many cases, and in the ECB’s case remains, an increasingly important part of the setting of monetary policy. In some cases, social goals became a part of the monetary policy goals. For example, the full employment mandate was at times interpreted through the lens of social outcomes in the labour market, and then post pandemic there was the re-emergence of the inflation challenge and of course, the enormous inflation overshoot that we've, you know, through the years of doing Macro Bytes talked about a number of times on the podcast.

And arguably, double digit inflation was a profound failure in monetary policy expertise, in forecasting and foresight. They were just missing their targets by a very large amount. And, flexible average inflation-targeting FAIT that you were talking about Luke played a part in that monetary policy failure by perhaps making the Fed too slow to react to the emergence of the inflation overshoot. In fact, let's hear from Max and from Aaron on their views on the scrapping of FAIT, which, as you'll hear they won't miss too much. 

Max Macmillan

So I think that by the time Powell did this, the framework had been all but dead for four years. I think 2021 made somewhat of a farce of the notion of average inflation-targeting. It was a measure which remember was very symptomatic of, you know, a decade-long period of inflation undershoot. And, and the Fed was sort of thinking that, you know, that undershoot might need to be remedied on average over time with sometimes letting inflation run a little bit hotter.  Indeed, in doing so, I do believe that it flirted, you know, dangerously with an incursion into non-monetary goals, such as social or climate goals. Obviously in 2021, you know, inflation shot so high above the Fed's mandate that I think that it had to rapidly put that framework aside. And, and towards the end of the year and in 2022 to reestablish its inflation fighting credentials.

And I think that since that point, you know, it's been a sort of awkward thing that the Fed has sought to, you know, not deny perhaps, but certainly minimize. And so we've really not heard about average inflation-targeting over the past three years as the Fed has sought to bring inflation back down to its actual target. So the fact that it is now formally given that up, I think is, not a big event, and it just confirms that they have reverted back to what they were before, which is to say, a central bank with no asymmetry around the setting of their policy with regard to inflation target.

Aaron Rock

So I think for bond investors and economists over the long run, this will be an important change and remove an element of confusion surrounding Fed policy intentions. The introduction of that FAIT or flexible average inflation targeting came after a period where the Fed struggled to get inflation up to 2%. Interest rates were stuck around the zero lower bound, and the backdrop was one of low growth and a very weak relationship between unemployment and inflation. Unfortunately for the Fed, almost immediately after that framework was revised and put in place, we then entered this period of higher inflation both during and after the Covid pandemic, and the environment shifted from one of too little inflation and a loss of faith that the central banks could hit that target from the low side to one of volatile and above target inflation and the debates about the Fed's willingness and ability to meet its inflation target from the high side. So I think what was particularly confusing for the market was how the Fed would react to periods of above target inflation. So I think retreat into this more traditional framework provides clarity for investors. However, I think it would go back to my opening comments that this is important for every bond investor and economist who are right into the weeds of this.

But at the moment, it does feel like markets are maybe more concerned with threats to the Fed's independence, the path of fiscal policy, the scale of the deficit, than they are to changes in the Fed's framework. I think sometimes we as investors and maybe economists and those in the Fed can be guilty of overemphasising the importance of changes such as these.

Luke Bartholomew

And then Paul returning to that history that you were giving from the post financial crisis period and where some of the roots of the current threats the Fed independence come from, I think the other important thing to note that occurred during that period is the significant increases in government debt levels. Of course, that was one big level shock higher in government debt loads after the global financial crisis and then again after, the pandemic. And I suppose, during the period after the financial crisis, that increase in debt load didn't have such a big impact on debt servicing costs for the government because interest rates were so low as you were describing it. But because of the inflation overshoot following the pandemic, interest rates of course, have gone up significantly and the way that's interacted with these now much higher debt loads is that it has significantly increased government debt servicing costs. And on top of that, many of the tools that you were describing, Paul, the unconventional policies that central banks embarked on during that period have fiscal consequences. So, during the period of QE, after the financial crisis, central banks were actually generating quite a lot of revenue. They were a source of revenue to Treasuries exchequers’ through their monetary operations. But in this period of higher interest rates, that's completely reversed and they are now a source of very big losses. They are a loss to Treasuries exchequers’ and that's, you know, shows up quite explicitly in the UK. In the US it's a bit more hidden in the accounting. But there are very clear fiscal consequences, quite large fiscal consequences, from these monetary policy operations. And so suddenly that fiscal monetary nexus that I was describing at the start there has become that much more pressing I think for a lot of politicians. They suddenly see the impact that monetary policy is having and potentially could have on the fiscal position. So look, no doubt Trump's specific political instincts, his willingness, desire perhaps even to push the ‘Overton Window’ on various things, try to move the debate on, shake up the way things are done, represents a unique challenge but I think it is also worth stressing and what this potted history that we've given there is meant to demonstrate that there are this confluence of factors that sort of represent the deep history to these threats to central bank independence. I mean, one way of thinking about this, and I think we've said this before on the podcast, is that you can think about these independent inflation-targeting in one form or another central banks as very much creatures of the end of history period. You know, that 1990s period after the Soviet Union collapsed, the US was the sole hyper power, there was a clear consensus about how the market, state, trade, financial markets should all interact with each other. But we are now in a period where, to coin a phrase, history is very much back with vengeance. A lot of those questions are now open questions again, we are past the period of single superpower US status.

We are in a multipolar, fracturing world and that perhaps is a world in which central banks may find that their role changes.

Paul Diggle

So we find ourselves at this current juncture in which the new risk is fiscal dominance, that monetary policy may be increasingly subsumed to the aims of fiscal policy. And as you raised earlier Luke the President has very clearly couched his arguments for lower interest rates in terms of reducing government funding costs. And that seems to be the aim of his interference, his politicisation of the Federal Reserve. I think it's interesting here to read closely the Federal Reserve Act, this 1913 legislation that lays out what the Fed does, because a careful parsing of that act will show you that the Fed doesn't actually just have a dual mandate, maximum employment and price stability. There's actually a third objective, in the Federal Reserve Act. It reads: “The Fed is to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” And for most of the history of the Fed or at least recent history, the consensus has been that bringing about moderate long-term interest rates is best achieved by fulfilling the dual mandate of maximum employment and stable prices for some of the reasons we heard about from Aaron earlier, that it can it anchor long-term bond yields to have an independent inflation-targeting central bank. But I wouldn't be surprised if this administration increasingly foregrounded the importance of that third hidden part of the Federal Reserve Act that says that they can act, they should be acting to encourage moderate long-term interest rates.

Luke Bartholomew

And then perhaps the final thing to say about fiscal dominance is that while this would represent a radical break from the way in which monetary policy has been conducted over, say, the last 30, 40, 50 years, perhaps the entirety of the period since the Treasury Fed Accord, that radical break doesn't have to happen necessarily in a single moment.

It could be something of a slippery slope, and you could plausibly imagine that there are sort of several phases of the process. And in the first instance, it is much more about, Trump or other administrations putting policymakers on the Federal Reserve Board who are just voting for lower interest rates than they might otherwise have been. And so interest rates are just a little bit lower each year than they otherwise would have been or is otherwise appropriate for the conditions of the economy. And maybe, maybe in the first instance that can be relatively supportive of growth, and stock markets - that these lower interest rates boost sentiment, they keep growth stronger. And yes, inflation is running a little bit above target, it's creeping higher, but it isn't radically higher at that point. But then, you know, you would in time expect expectations to start to catch up with this process that you get these accelerating inflation expectations because each year inflation creeps higher and higher and higher, expectations try and get ahead of that higher inflation. And that embeds this vicious circle of accelerating inflation expectations. And so in this second phase, inflation expectations pick up significantly and the compensation the investors demand for longer-dated securities increases significantly in response to that risk of much higher inflation. That is to say, government bond yields would increase significantly and government borrowing costs would therefore also increase. And at that point, you know, you've started to undermine the very thing that you wanted to do by politicising the Fed -bring about fiscal dominance - which is to say reduce the government borrowing costs. And so this could bring you into the third phase of fiscal dominance, where the central bank then has to, as I've talked about, mobilise its balance sheet to keep, long-dated yields under control. And that could be through, as we’ve talked about, asset purchases, yield curve control, and perhaps, you know, other forms of financial repression as well, forcing domestic savers to invest in sub-market rates, perhaps in the case of the US, forcing foreigners to swallow some of this loss as well. And you would imagine this is a situation in which certain asset prices that weren't being directly controlled by the Federal Reserve would react really quite significantly. Perhaps this environment where the likes of gold would perform extremely well. But anyway, all of which is to say, though, that yes, just because this would represent a radical break from past monetary history, it could be a staggered process by which the market, investors, households, firms come to understand this big shift has occurred and that perhaps that sort of makes sense, to some extent why the market so far hasn't reacted particularly significantly to  some of these developments we've been describing. But anyway, that is all that we have time for on Macro Bytes this week. So as ever, please forgive me if I ask you again to like and subscribe to the podcast if you have not already done so. Then all that remains is for me to thank Max and Aaron for joining us today and thank you for listening. So thanks very much and speak again soon.

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