USD: Is fiscal dominance coming? – Commerzbank

After a nine-month pause, the US Federal Reserve is expected to resume its cycle of interest rate cuts this week. The big question is how far will it go? US President Trump has already made it clear that he wants to see cuts to a key interest rate of around 1% (from the current 4.25-4.50%), and probably as quickly as possible. Given the risk of stagflation in the wake of US tariffs, such a sharp easing of monetary policy would be disastrous for the US Dollar (USD), Commerzbank's Head of FX and Commodity Research Thu Lan Nguyen notes.

Trump wants the Fed to help the Treasury finance the national debt

"Trump's motives are clear. He pointed out himself that the Treasury would save USD 1 trillion if interest rates fell to such a low level. In other words, he wants the Fed to help the Treasury finance the national debt. The technical term for this is 'fiscal dominance'. In this case, monetary policy is not primarily guided by the mandate of price stability (and maximum employment), but by the affordability of government debt. This causes the central bank to lose credibility, which in the worst case can lead to a significant increase in inflation expectations and ultimately to currency destabilization."

"Both Trump's Treasury Secretary, Scott Bessent, who is leading the search for a new Fed chair, and Stephen Miran, who could take Fed Governor Adriana Kugler's place on the FOMC as early as this week, have in the past, or in Bessent's case only recently, expressed criticism of an instrument that is important for fiscal dominance. Namely, QE (quantitative easing), the central bank's asset purchases. Miran criticized that the use of QE to combat the Great Financial Crisis had not been subject to political oversight. Bessent even questions the effectiveness of QE and points to unintended side effects."

"Bessent's views in particular could have important implications. He argues that QE should only be used in crisis situations and should be halted as soon as they end. This could indicate that Bessent is in favor of a faster reduction of the Fed's balance sheet. The central bank has already significantly reduced its balance sheet following the pandemic in order to combat accelerating inflation. However, the pace of reduction has slowed again since spring this year. A return to faster reduction, especially of government bond holdings, would reduce the effectiveness of the interest rate cuts demanded by Trump – which in turn would benefit the US dollar."