MNI INTERVIEW: US Faces Growing Fiscal Dominance Risk-Leeper
MNI (WASHINGTON) - Ballooning U.S. deficits and a lack of political resolve to tackle them are pushing the American economy toward a situation of fiscal dominance that make it harder for the Federal Reserve to control inflation, Eric Leeper, a former Fed economist and adviser to global central banks, told MNI.
“We are staring at growing fiscal dominance in the United States,” said Leeper, a former staffer at the Atlanta Fed and the Fed's Board of Governors. “I don’t see massively different outcomes by the two parties in terms of fiscal behavior.”
A budget deficit that exceeded USD1.8 trillion fiscal 2024, the third largest on record, provides a boost to economic activity – and inflation – that Fed policymakers would be ill-advised to ignore, said Leeper, who has also advised the Riksbank and the Bundesbank.
“My big worry is that there’s no adjustment in fiscal policy in sight. That doesn’t bode well for keeping inflation down to tolerable levels,” said Leeper, a professor at the University of Virginia and a proponent of the Fiscal Theory of the Price Level. “Even though the Fed has lowered rates, interest payments on government debt are rapidly increasing.” (See MNI INTERVIEW: CBO's Swagel Sees Fiscal Headroom In Near Term)
He says the Fed’s aggressive rate hikes, which took borrowing costs to 23-year highs, served to temporarily dampen the inflationary impulse but is not likely to have permanently extinguished it.
“Inevitably if you keep pumping more nominal debt into the economy and there are no adjustments to primary surpluses, inflation’s got to rise.”
DEGREES OF DOMINANCE
Leeper said it’s hard to make predictions about exactly when the fiscal impulse will be felt as another burst of inflation because concerns about the sustainability of the Treasury’s debt burden are likely to play out in sudden and unpredictable fashions.
“It’s a bit like a run on debt, or if you think about a currency crisis, it’s like a run on the currency. What happens is the sentiment about that asset start to move in a direction that makes people more and more worried about its value. And when that happens it can happen really fast,” he said.
Broader fiscal dominance, in contrast, can creep up more gradually and thus go unnoticed until it’s too late, he said.
“It can sneak up on you. In the theory, it’s always very clean, you’re either there or you’re not there. In practice, I think there are degrees of fiscal dominance and they can change over time.”
He said factors like the rise of populism, political polarization, high inequality and an aging population make the debt problems more intractable and thus less likely to be addressed outside of a crisis. (See MNI INTERVIEW: US Budget Deficit Unsustainable - Ex-CBO Chief)
“These factors make it much harder for elected officials to reach compromise – fiscal consolidation is completely about compromise. Views need to coalesce around the urgency of fiscal consolidation. I’m not so confident that that’s going to recur,” Leeper said. “All of this is pushing toward greater fiscal dominance.”