Pre-budget speculation is a tedious exercise at the best of times but this year it promises to become a wretched drawn-out borefest. We have already had a fortnight of property tax kites being flown and there is, thanks to the government’s decision to put the big day right at the end of November, another 12 weeks to go.
The real problem, though, is that all the attention is on the minutiae rather than the important issues. It is easier to obsess about which group will be more affected — homeowners versus farmers versus pensioners versus families — than to concentrate on the big underlying forces shaping the economy.
One of those forces is a phenomenon that economists call fiscal dominance. That is when a government’s financing needs to override the policies of the central bank, in other words monetary policy (the central bank’s remit) becomes subservient to the government’s fiscal (spending) requirements. It is a concept that has been around for a long time and that has many historical examples, but it fell out of the mainstream from the late 1990s when western economies grew, inflation gradually calmed down, deficits were smaller and governments were content to let central banks get on with their job.
Now, though, lots of economists are talking about it again. The reason for the renewed interest is, you guessed it, Donald Trump. He wants the US central bank to cut interest rates and cut them hard. He cannot just snap his fingers, however, because the US central bank is, like the Bank of England, independent. It has control of interest rates and is charged with setting them at the right level to control inflation.
Trump wants his way, however, and is piling on the pressure. There have been savage public attacks on Jerome Powell, the Fed’s governor, and now Trump wants to sack Lisa Cook, another member of the Fed board and a Joe Biden appointee. The way in is claims against her of alleged mortgage fraud. Cook’s lawyers have denied on her behalf any wrongdoing.
The US Department of Justice began an investigation into those allegations this week. Cook is making a separate legal challenge to Trump’s manoeuvres, arguing that the president lacks the authority to remove her.
Cook is important. If she goes, Trump names the replacement. He already has one new board member, Stephen Miran, whose appointment is waiting to be confirmed. With the addition of a Cook replacement, the majority of the Fed board would be loyal to him.
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Why does Trump want the Fed to cut rates? He has several reasons. Lower rates should boost US growth, juice the stockmarket, counteract the effects of his tariff programme, lower unemployment and help the housing market. And it would make him more popular with voters, which might be the biggest motivation of all.
There are, though, some quite nasty potential downsides. The biggest is inflation, which would probably be let loose by lower rates and resurgent growth. There could also be a nasty sting in the tail on borrowing costs. Investors who buy US treasuries, the equivalent of gilts, rely on central bank independence.
Inflation kills bond returns so the investors need to know that when it starts to rise the bank will increase interest rates to bring it under control. If Trump is running the Fed, that vital protection is gone. They will demand higher and higher returns to buy treasuries, saddling the government with a growing interest bill. America is already forecast to spend $1 trillion on interest payments this year, roughly the same as it spends on defence.
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There is another twist to this. The US might spend more on interest but higher inflation would over time eat away at the value of the dollar, and the value of the outstanding debt. This is a tried-and-trusted way for governments to deal with deficits. Cutting spending and running a surplus is difficult and extremely unpopular with voters. Letting inflation run and the economy grow achieves something similar by stealth. The big losers are those on fixed incomes, who have to watch the value of their investments dwindle.
Here in the UK there does not seem much danger of Trump-style interference with the Bank of England. That does not mean, however, that fiscal dominance is not making itself felt. In the run-up to the Liz Truss mini-budget three years ago the Bank of England was making its first steps in quantitative tightening (QT), running down the stock of gilts that it had built up during the banking crisis and the Covid-19 pandemic.
When the gilt markets went crazy in the days after the budget, the Bank was forced to reverse course, saying that it would buy bonds on any scale necessary to stabilise the market. Fiscal policy forced a change in monetary policy: fiscal dominance. If, as expected, it decides to slow the pace of QT, will that be the sensible management of monetary policy or fiscal dominance again?
It would probably be wrong to make value judgments on all this. Fiscal dominance is not necessarily good or bad; it is useful, however, in understanding what is going on and the ramifications of having precarious public finances.
There could be some other consequences for the government. One of the most talked-about economic papers on fiscal dominance was published in 1981 by two celebrated US economists, Neil Wallace and Thomas Sargent. “Some Unpleasant Monetarist Arithmetic” argued that when governments have a big enough deficit even a feisty independent central bank will struggle to control inflation on its own.
If it bumps up interest rates the higher payments on government debt push money into the economy and force up inflation, a kind of doom-loop that makes inflation hard to control. Wallace and Sargent concluded that unless the central bank received assistance from fiscal policy — ie, the government cut its spending — inflation would be difficult to tame.
Rachel Reeves and Andrew Bailey, the governor of the Bank of England, will be thinking about this in the (lengthy) run-up to the budget and the two interest rate decisions that will precede it, on September 18 and November 6.
Inflation is on the rise again after briefly coming back to target last year. Might Reeves be happy to take a risk with letting inflation run in the hope that growth will come with it, and the value of the UK’s outstanding debt be eroded a little for good measure?
And will Bailey and the other rate-setters on the monetary policy committee be happy to go along with that, reasoning that a slowing economy and labour market is the greater of two evils? Whatever their eventual decision, the parlous state of the government’s finances will have weighed heavily in their thinking: fiscal dominance in action.
Dominic O’Connell is business presenter for Times Radio