Still on the Road to Financial Repression

As with all economic theories, observers are faced with the usual two-handed economist (on one hand, this…on the other hand that…). Nevertheless, the striking results of this paper provides political cover to fiscal authorities on both sides of the aisle. There is little appetite in Washington for fiscal austerity, despite current deficit levels of about 6% of GDP. The current and future administrations will undoubtedly point to these results and proclaim, “deficits don’t matter (very much)”.

That said, the Economist reported that Ludwig Straub, who presented the paper on stage, admitted “that the 250% number applied only in 2100, not today, and also that today’s deficits are not sustainable. ‘We need a massive fiscal adjustment no matter what.’”
 

 

An Invitation to Financial Repression

Regardless of which hand of the economists are right, the risk is that this paper provides license for fiscal authorities to engage in financial repression and force a regime of fiscal dominance.

This brings us to the Lisa Cook Affair. President Trump announced last Monday on Truth Social that he was firing Lisa Cook as a Governor of the Federal Reserve as a blatant assault on the Fed’s independence.
 

 

In reality, the announcement was just that — an announcement. Cook has said she will not resign and the matter will undoubtedly wind up in court and probably ultimately at the Supreme Court. In the interim, the courts will probably allow Cook to stay in her position until a final decision is rendered.

Cook is accused of mortgage fraud when she allegedly applied for two different mortgages for two different properties at different locations and declared that each would be her residence. There are many legal issues involved in this case, but this is an example of the Trump Administration flexing its muscles to gain leverage over the Fed’s board. The law governing the termination of Fed governors states that governors may be fired “for cause”. At this point, Cook is only accused of wrongdoing. She hasn’t even been charged with a crime, much less convicted. In addition, Cook also argued that she cannot be fired “for cause” for acts that are not proven and done before she became a Fed governor. All of these issues will have to be decided by the courts.

Here is the Doomster scenario. Assuming that Cook is forced out, Trump could appoint a replacement and at least four of the seven board members would be Trump allies (Waller and Bowman, who dissented on the latest rate decision, Miran, Kugler’s temporary replacement, and replacement for Cook, plus another likely vacancy once Powell serves out his term as Chair, though his term as governor technically ends in January 2028). With a four or five of seven seats on the board, Trump would still be short of a full majority on the 12-seat interest rate setting FOMC, whose members consist of regional Fed Presidents appointed by local boards. However, a new slate of Fed presidents will be appointed in February 2026, and the Fed’s Board of Governors has veto power of the appointments. In theory, Trump Fed governor allies could transform the FOMC into an organization friendlier to Trump’s propensity for low interest rates. Moreover, the Federal Reserve Act states that the Fed Board can dismiss officers, such as regional presidents, “at pleasure”.

A Federal Reserve that’s under the full control of the White House has far greater implications beyond lower interest rates. The Fed has a unique power inasmuch as it controls a balance sheet with theoretical unlimited expansion capacity. A President who controls the Fed and its balance sheet would no longer be constrained by Congressional funding authority. He could direct spending power in any manner that pleases him without any checks or balances, and in a way that the original framers of the U.S. constitution never contemplated.

That said, the doomster scenario is unlikely. Fed governors Michelle Bowman and Christopher Waller are technocrats and institutionalists who have strong views on Federal Reserve independence. While their views on monetary policy have been dovish, it would be too great an assumption that they would acquiesce in a full takeover of the Fed by the White House.

However, a Trump takeover of the Fed raises another kind of tail-risk. The Fed stands as a key backstop of global financial stability in the event of a crisis. It maintains USD swaps with other major central banks to provide dollar liquidity so that foreign central banks can borrow dollars from the Fed and re-lend to their own banks in the event of major market disruptions. A Trump-dominated Fed could impose conditions on dollar swaps, which raises the tail-risk of exacerbating global financial instability in a crisis.

The Lisa Cook Affair along with Trump’s relentless pressure on the Fed to cut rates are clear signals that fiscal authorities are trying to exert control of monetary policy. A successful takeover translates into forms of financial repression. Not only would short rates be forced down, but also the Fed would engage in quantitative easing and yield curve control to keep long rates from rising. Inflationary expectations would rise and the USD would fall.What does this mean for the economic outlook? A paper by Thomas Drechsel, “Estimating the Effects of Political Pressure on the Fed: A Narrative Approach with New Data”, quantified the effects of interference with Fed independence. Drechel measured the number and duration of President-Fed meetings and found a high number of encounters had significant effects on inflation. Most presidents interacted with the Fed Chair relatively few occasions in a year. The major exception was the Nixon-Burns interactions of the early 1970s.
 

 

Drechel found that the impulse response function (IRFs) of political pressure, as measured by the number of interactions, usually showed a short-term reaction followed by a longer-term mean reversion. Political pressure initially depresses short-term rates, raises real government spending and GDP growth, and deficits per GDP. The price is a prolonged effect on inflation, as measured by the GDP deflator. These results are consistent, even outside the Nixon years.
 

 

The most striking results are the IRF effects on inflation expectations of political pressure (blue lines) compared to monetary shocks (red lines).
 

 

Here is a real-life example of the value of central bank independence. In Jerome Powell’s Jackson Hole speech, he discussed the issues of the upside risks to inflation and downside risks of employment. He ultimately came down on the employment risks because of the non-linear effects of employment loss, and how it could spiral out of control. Powell wouldn’t have been able to credibly pivot in such a fashion without the market believing he has the will to keep inflation expectations well-anchored.

Even the WSJ’s editorial page warned against such blatant interference with Fed independence:

We know from history what happens to central banks that become arms of politicians. See inflation in Turkey under President Recep Tayyip Erdogan and in Argentina for decades. Richard Nixon jawboned then Chair Arthur Burns to keep monetary policy easy, and the result was the 1970s great inflation…Mr. Trump is all about short-term tactics and personal political advantage. Institutional integrity bores him. But if he succeeds in taking over the Fed, he and Republicans will own the results and whatever inflation returns.

A separate academic paper presented at Jackson Hole this year by Nakamura, Riblier and Steinsson called “Beyond the Taylor Rule” focused on central bank credibility and adherence to a rule-based regime like the Taylor Rule for setting interest rates. It discussed how the Fed partially looked through the pandemic-related inflation shock and found “central banks with strong inflation-fighting credentials looked through post-COVID inflationary shocks yet experienced less inflation than more hawkish but less credible central banks.”

In her presentation, Nakamura discussed why the Taylor Rule performed poorly since 2008 and the problems with its strict application, especially in relation to apparent temporary inflation shocks. Seeming addressed as a comment to Governor Christopher Waller, who argues that the Fed should also look through the tariff-related inflation shock as a one-time event, the paper concluded: “Only central banks with strongly anchored inflation expectations and large amounts of inflation-fighting credibility are likely to be able to look through inflation shocks”.
 

 

Investment Conclusions

From the market’s perspective, Trump’s relentless attacks on the Fed in different directions are having an effect. Already, my suite of inflation factors are rising. TIPs are outperforming long-dated zero-coupon Treasuries. The long end of the yield curve, the 10s30s, is steepening and the 30-year yield is in an uptrend. If the 30-year yield were to rise through the dotted resistance level that would be a signal of a possible bond market tantrum.
 

 

In conclusion, an important and controversial research paper was presented at the 2025 Jackson Hole symposium. The paper modeled the supply and demand for U.S. Treasury debt and came to the startling conclusion that “debt could reach 250% of GDP without pushing up interest rates”. While there were some holes in its assumptions, the paper offers cover for fiscal authorities to declare that “deficits don’t matter (very much)”. The risk is that it provides a license for fiscal authorities to engage in financial repression and force a regime of fiscal dominance, inflation and a falling currency.

For investors, the best hedge fiscal dominance is a combination of equities and hard assets. I reiterate my view that investors should focus on a barbell portfolio of U.S. large-cap growth for their AI growth potential and non-U.S. value stocks, which have exhibited a multi-year trend of outperformance.