Will the Next Fed Chair Matter Much to Policy?

As reporters tried to elicit the Fed’s reaction function from Jerome Powell during the July post-FOMC press conference, Bloomberg’s Michael McKee asked a very different question relating to the juxtaposition of fiscal and monetary policy in the years ahead:

McKEE: Do you have concerns about the cost to the government of keeping rates elevated for longer in terms of interest rate charges?
POWELL: We have a mandate, and that’s maximum employment and price stability. It’s not something we do to consider the cost to the government of our rate changes. We have to be able to look at the goal variables that Congress has given us, use the tools they have given us to achieve those goals. That’s what we do. We don’t consider the fiscal needs of the federal government. No advanced economy’s central bank does that…If we did do that it wouldn’t be good for our credibility nor the credibility of U.S. fiscal policy. So it’s just not something we take into consideration.

The question highlights the difficult head facing the U.S. Treasury and the Federal Reserve in the coming years. How will the government cope with higher interest expense from the growing debt, and what steps will the Fed take to cushion the blow? Powell reverted to the textbook answer of the Fed’s dual mandate, which also subtly underlined the importance of central bank independence.

Such an approach may not be sufficient for future Fed Chairs. Trump has already made it clear he wants the Fed to cut rates. Regardless of who he appoints, the next Fed Chair will face increasing pressure to bend monetary policy to the needs of the growing interest burden from fiscal policy. While it’s highly likely that the next Fed Chair will be more dovish than Powell, it may not matter given the pressures. Future Fed policy is becoming subservient to fiscal policy.

Welcome to the era of Fiscal Dominance.

 

 

The Fiscal Picture

The accompanying chart shows the projections of U.S. federal spending from the nonpartisan Congressional Budget Office (CBO) that were made in January 2025. While the primary deficit was expected to stay steady as a percentage of GDP, net interest expenses were projected to grow steadily over the next 10 years.
 

 

Those projections don’t take into account the effects of the just passed OBBB Act, which the CBO estimates will add another $3.4 trillion to the deficit over the next 10 years. I would add, however, that the deficits (and therefore fiscal stimulus) are front-loaded and savings are mainly back-loaded.
 

 

 

Treasury’s Coping Technique

How will the U.S. Treasury and the Fed cope with this giant wall of debt?

I am old enough to remember that when Treasury Secretary Scott Bessent assumed his post, he declared that the Trump Administration was primarily focused on the 10-year Treasury yield and it wasn’t as concerned about short-term rates. Fast forward a few months, President Trump has publicly berated Chair Powell for not lowering short rates.

What’s Bessent’s plan for coping for these fiscal challenges? Despite criticizing his predecessor Janet Yellen for financing the fiscal deficit with bills instead of long-dated coupon paper and failing to lock in low bond yields, Bessent has stuck to a similar mix of bills and bonds.

The latest Quarterly Refunding Announcement (QRA) was set at $125 billion, which was in line with market expectations. The U.S. Treasury will issue $125 billion in new debt in Q3 to refinance maturing bonds and raise cash to refill the Treasury General Account that was run down as part of the extraordinary measures to cope with the approaching debt ceiling. The financing schedule for longer-dated paper was essentially unchanged from the past two quarters. This was a status quo go-slow approach by the Bessent Treasury and a signal to the bond market that the Trump Administration doesn’t want a steepening of the yield curve.
 

 

 

The Fed’s Reaction

What about the Fed? The WSJ reported that Fed watcher Tim Duy, chief U.S. economist at SGH Macro Advisors, said, “There’s a feeling that Trump has an influence over every institution sooner or later, and maybe the Fed’s ability to resist it has come to an end.” Trump will be Trump, and the cordial relationship between the President and the Fed Chair lasted only one week.
 

 

Several developments last week will have Fed policy implications that will not endear Fed policy makers to President Trump. First, the Fed’s preferred inflation metric, core PCE, rose 0.3% in June, indicating an upward acceleration in tariff-related inflation. Core PCE has exhibited an unwelcome three-month trend of steady monthly increases.
 

 

As well, the Trump Administration announced a new tariff regime on July 31 that is scheduled to go into effect August 7 targeted at numerous countries without trade deals. This means the tariff pass-through effects to inflation won’t be realized until late 2025 and early 2026, which cautious Fed decision makers may wait to ascertain their effects if the price increases are a one-time event or persistent before making any changes to monetary policy. This will inevitably delay the timing of the first rate cut until, at a minimum, the December FOMC meeting.

On the other hand, the July Jobs Report came in much weaker than expected. Headline employment was 73,000, which was short of consensus expectations of 100,000. The real shocker was the revisions. June was revised from 147,000 down to 14,000, and May dropped from 144,000 to 19,000. The unemployment rate edged up from 4.1% to 4.2%. This was a game-changer report. The post-tariff job gains proved to be illusory, and it supports the case for a September rate cut.
 

Watch for the debate to begin. Nonfarm payroll employment has been inversely correlated with initial jobless claims. Does the recent improvement in jobless claims foreshadow a strong jobs market ahead?
 

 

Whoever Trump appoints as Fed Chair will have a more dovish tilt than Powell in the short run. In the long run, how far will the Fed go to accommodate the fiscal needs of the U.S. Treasury’s financing needs? The Fed bought most of the Treasury’s issuance during the COVID Crisis, but that was a crisis. Will it acquiesce to the administration’s demands in the future, or will it cite its dual mandate as Powell did during the recent press conference?

Notwithstanding the overt pressures on the Fed made by the current occupant of the White House, it is clear that there is little appetite in Congress on either side of the aisle to control fiscal spending. Deficits are expected to grow as far as the eye can see. The only question is the trajectory. Regardless of who occupies the Oval Office and the Fed Chair, the Fed will inevitably have to take some measure to accommodate the federal government’s financing needs.Investors can look to Japan for a history lesson for how central banks coped during an era of fiscal dominance. It isn’t just enough to lower short rates. If the Fed were to cut rates to levels that’s clearly not justified by some variation of the Taylor Rule, bond market vigilantes will act and steepen the yield curve. In order to control the government’s financing costs, the Fed will have to restart quantitative easing, as well as engage in yield curve control (YCC) to keep long rates from rising.
 

 

In other words, financial repression. The price to be paid will be inflation and a falling exchange rate.
 

Investors can see the effects of financial repression in the price of gold, which acts as a barometer of unexpected inflation and inflation hedge, as measured in USD (blue line) and JPY (red line). The BoJ engaged in a stop-start series of rate cuts during the first decade of Japan’s Lost Decades that began in 1990. It wasn’t until about 2000 that rates reached the zero bound, and gold coincidentally bottomed in both USD and JPY. When gold topped out in USD in 2012–2014 and began a bear market, its price was flat in JPY terms during that period. Gold resumed its bull phase in 2019 in both currencies.
 

 

The price of gold is already discounting a scenario of fiscal dominance and financial repression. Gold staged upside relative breakouts against both the S&P 500 and the 60/40 portfolio.
 

 

More importantly, growing deficits are becoming a problem not just in the U.S., but also in most advanced economies around the world. Fiscal dominance is coming for virtually all global investors.
 

 

Investment Implications

Against this backdrop of fiscal dominance, investors need to re-examine their investment objectives and policies under the new regime. Risk and volatility will rise as fiscal dominance becomes apparent. It may not be enough just to focus on risk-adjusted returns, but on risk-adjusted real returns.

Under such conditions, the best hedge for inflation-adjusted returns will be equities — global equities. An overweight in the U.S. market is a big bet on AI-related productivity gains, which may not be fully realized or already discounted by price. Investors need to hedge against USD devaluation risk by holding non-U.S. equities for their inflation hedge characteristics, as well as their non-USD exposure.

Bonds will still have diversifying characteristics when held with equities, but not as much and their return correlations to stocks will rise. Gold and commodities, in measured amounts, will act as better counterweights to inflation shocks under a regime of fiscal dominance.