President Donald Trump has made no secret of the fact he wants to lower interest rates to reduce the cost of servicing US public debt. He said repeatedly last year that his nominee for the next Federal Reserve chair should lower interest rates to 1 per cent. He also told his administration in July to issue only short-term debt so that it could save money once a new chair was in place and had lowered rates.
If the Fed and US Treasury had complied with these presidential missives, central bank independence would be gone.
A group of leading global central bankers, including European Central Bank president Christine Lagarde, Bank of England governor Andrew Bailey and Bank of Canada governor Tiff Macklem, issued a thundering statement on Tuesday morning. “The independence of central banks is a cornerstone of price, financial and economic stability in the interest of the citizens that we serve,” they said. As I have repeatedly argued, this is slightly overstating the case. The value of independence must be shown in better economic policy — and, in the US case, the avoidance of fiscal dominance.
Fiscal dominance is the situation in which a government forces the central bank to finance the government cheaply. It ends badly, Janet Yellen, former Fed chair and US Treasury secretary, told Brookings last week. If the Fed keeps interest rates lower than warranted by economic conditions to ease government financing, “it typically results in higher and more volatile inflation or politically driven business cycles”, she said.
Yellen added that although there were dangers in the US, the evidence suggested the country had not slipped into fiscal dominance. The Fed had raised interest rates sharply since 2022 to counter inflation without regard for the additional financing costs for the government, she said. These costs were significant, as the chart below shows. Interest payments as a share of GDP are at or very close to record levels, whether you take the IMF or Congressional Budget Office statistics. The US Treasury also did not take much notice of Trump’s calls in 2025. Although it shortened US debt maturities, as did many countries including the UK, it continued to issue long-dated bonds.
What a difference a week makes.
On Monday, the Trump administration’s criminal probe into the Fed’s office renovation forced Yellen to U-turn. She joined former Fed chairs in slamming the president’s criminal probe into Fed chair Jay Powell, and added: “People inside the Fed will view this development as really alarming and see it as a statement that Trump absolutely intends to gain control over monetary policy.”
That is also clearly Powell’s view. In his statement, he highlighted just how damaged his relationship with Trump has become:
This new threat is not about my testimony last June or about the renovation of the Federal Reserve buildings. It is not about Congress’s oversight role; the Fed through testimony and other public disclosures made every effort to keep Congress informed about the renovation project. Those are pretexts. The threat of criminal charges is a consequence of the Federal Reserve setting interest rates based on our best assessment of what will serve the public, rather than following the preferences of the President.
There is little doubt this will end messily.
When Trump picks a new Fed chair in the coming days, his nominee cannot back the Fed over the president. Markets might have reacted calmly because they think the administration is all bark and no bite. But they will become more wary of US economic institutions if they are led by appointees who take orders from the president.
Unless Congress grows a spine, we can expect a new Fed chair to find pretexts to lower interest rates as I wrote in my column last week. This might be good for markets in the short term. Everyone loves a boom, until sentiment turns. More importantly, this is what fiscal dominance looks like.
Trump’s Fed probe was not the only thing to undermine Yellen’s speech last week. The day after she spoke, Trump announced on Truth Social that he had agreed an increase to the defence budget of 50 per cent by 2027 to $1.5tn to build his “dream military”. It would be funded by tariff revenues, which would also be able to “pay down Debt, and likewise, pay a substantial Dividend to moderate income Patriots within our Country!”
There is no evidence for any agreement to increase defence spending and, as the Committee for a Responsible Federal Budget highlighted, tariff revenues would not remotely meet this uptick in military expenditure. If the plan were attempted, there would be extra debt and no room for dividends.
The chart below shows the relevant numbers, which I have converted to a share of US GDP so they are more meaningful. If the US Supreme Court strikes down the tariffs enacted via the International Emergency Economic Powers Act, there will be even less money to spare.
The following day there was some bipartisan action in the House of Representatives, with 17 Republicans joining the Democrats to vote for a three-year extension to the higher Affordable Care Act subsidies that were withdrawn at the start of 2026. There is no guarantee the Senate will concur. But the vote demonstrates that the only likely action from Congress will be to raise rather than lower the deficit.
Also last Friday, Trump announced that Fannie Mae and Freddie Mac, the government-backed enterprises tasked with buying lenders’ mortgage loans and repackaging them as mortgage-backed securities, would buy $200bn of mortgage bonds to improve housing affordability. This is a financial transaction rather than simple government spending. But it again demonstrates that the US administration is not great with large numbers. The Fed already owns $2tn in mortgage-backed securities and, as the chart below shows, US 30-year mortgages average just over 6 per cent because the US long-term interest rate is around 5 per cent. So this will not have much impact.
Yellen’s speech is worth a re-read. It was right on all fronts, but time was running much faster than she imagined.
There had been no sign of US fiscal dominance when she gave the talk, and she was correct to warn that “the dangers are real”. But the rest of last week signalled the US has little control of fiscal policy — and the administration has demonstrated it will go to any length to ensure the central bank accommodates an expansion.
These are difficult times in central banking.
Vile visuals
The ECB’s blog has done everyone a favour by highlighting how uniformly terrible central banks’ visual summaries of their policies are. That, of course, was not the ECB’s conclusion. Instead, it said that when it comes to communicating monetary policy, “it’s time to picture it”. With a threatening tone, it added: “Not everyone is convinced that pictures really help communication — yet.”
The example I enjoyed is below about Namibia. Its brutal honesty was refreshing. “Economic models are presently defunct,” it said. You can agree or disagree, but I’ve no idea how this message was helped by pictures of an arrow-shaped boat, sail, oar and men dressed for a night out.
What I’ve been reading and watching
One last chart
Here is a paradox. Researchers at the San Francisco Fed have found that tariff increases are associated with drops in inflation, especially before the second world war.
Authors Regis Barnichon and Aayush Singh suggest that tariff upticks a century or so ago tended to increase unemployment and uncertainty, lowering inflation. They suggest it might be different today (and we have good evidence that it is different). But the work demonstrates that we need to think always about disinflationary as well as inflationary forces when we examine policy changes.
Central Banks is edited by Harvey Nriapia