MNI INTERVIEW: Fiscal Dominance To Fan US Inflation-Leeper

The U.S. economy has slipped into a period of fiscal dominance that will leave the Federal Reserve with the uncomfortable choice of accepting more elevated inflation or risking market upheaval, former Fed economist and University of Virginia professor Eric Leeper told MNI.

Fed Chair Jerome Powell has “got to have in his mind that we’re likely to have more inflation generated by what fiscal policy is doing,” said Leeper, who spent eight years in the Fed system and is currently on the advisory council of the Atlanta Fed’s Center For Quantitative Economic Research, in the latest episode of The FedSpeak Podcast.  

“We’re constantly putting more nominal liabilities into the world economy, and we’re not seeing any increase in the primary surplus that would provide more backing for those liabilities – so inevitably the price level is going to have to keep going up.”

President Donald Trump’s relentless pressure on Powell and his FOMC colleagues to lower interest rates for the explicit reason of lowering the government’s interest costs exemplifies the extent of the U.S. economy’s current fiscally-dominant state, Leeper indicated. 

“This is actually unprecedented. Presidents have always wanted lower interest rates and browbeaten Fed chairs in various ways, usually in private. This, as far as I can tell, is the first time it was linked explicitly to interest payments,” he said.  

Chatter over Trump’s possible firing of Powell reached fever pitch this week after reports, later denied by Trump, that he had told Republican lawmakers the White House was getting ready to take that unprecedented step. (See MNI INTERVIEW: Powell Firing Would Set Off Legal Battle-Menand)

“Trump’s strategy with the Fed, if he has one, is to try to return to the pre-Treasury accord days, when essentially the job that the Fed performed was to keep bond prices high and allow the government to finance its debt inexpensively. I think that if he can get them back to that point, he will be very happy – but that will almost inevitably mean more inflation.”

FISCAL FOCUS

Leeper worries the U.S. central bank will continue to misread the trajectory of inflation if it ignores its fiscal inputs, as it did during the Covid pandemic. 

“The Fed's view that inflation was going to be transitory was entirely driven by thinking about relative prices changing without taking into account the USD5 trillion of fiscal stimulus that got fed into the economy,” he says. 

Rather than focus on tariffs as the top potential source of higher inflation, which Leeper agrees with Fed Gov. Chris Waller is unlikely, Fed officials should instead focus on how to navigate the tradeoffs of a fiscally-dominant world. 

“The Fed really needs to be thinking about how should it function in an environment where fiscal policy is dominant and you cannot count on the kinds of fiscal adjustments that we have seen historically,” he said. 

“The Fed is in a box. It has a mandate to control inflation and achieve maximum output, but at the same time it is also supposed to maintain stable financial markets. And if financial markets are getting jerked around because the Treasury is issuing so much new debt that they just can’t absorb it, what’s the Fed supposed to do, let the Treasury market crash? That would be disastrous.”