Janet Yellen, who served as both Treasury Secretary and Fed chairman, presented "The Future of the Fed: Central Bank Independence and Fiscal Dominance" at the AEA convention earlier this month. She does a thoughtful job of describing the differences between these two forms of dominance, yet she misses the mark in her description of the current environment.
We cannot continue independence and monetary dominance if there is a fiscal crisis. Fiscal policy saw periods of deficit and then a return to something normal; however, in the last decade, or since the Great Financial Crisis, there has been a change in government debt dynamics, so that fiscal policy has a more dominant role in monetary policy. Dominant does not mean controlling. In this example, fiscal dominance means the issues with fiscal policy have a more dramatic impact on the economy than monetary policy.
The current debt levels cannot be sustained with a growing amount of tax revenue used to pay interest on debt. The Fed has ignored this fiscal crisis. They have refused to comment on rising debt-to-GDP ratios to avoid being political. Yet the ongoing QE process, coupled with Fed high Treasury balances, shows that the Fed has lost its monetary dominance and must deal with a debt crisis.
Trump's desire to lower interest rates is just an extreme manifestation of the fiscal dominance needed to sustain current government policy. Let's not forget that inflation is one way of getting out of a fiscal bind. If there were controlled deficits, there would not be a need to discuss lower interest rates. The fiscal excesses of the past have to be addressed. Yet, who wants to say we have a debt problem?
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