Over the past couple of weeks, we have seen unusually open debates and divergent views about the path of short-term interest rates among the committee members of the US Federal Reserve (the Fed) and the Bank of England (BoE). Professional Fed watchers are in a spin. What is the problem all of a sudden? And why is the debate happening so publicly? Where is the certainty previously displayed by these policymakers, always confident that they can control inflation via the setting of short-term interest rates? All is not right in the rarefied world of central banking.
The cornerstone of monetary policy in recent decades has been the perceived independence of central banks from political influence. The idea was that we could trust politicians more if our monetary policy was set and executed by an independent technocratic committee of experts acting in the public interest. UK gilt investors welcomed this initiative in 1997 when Gordon Brown granted the Bank operational independence.
But things have changed. The UK electorate has grown to distrust its politicians and its institutions. The British Social Attitudes Survey in 2000 showed that 35%-40% of adults believed that the government would put the country’s interests first. Last year, the same measure was 9%-14%, with 58% saying that they rarely trusted politicians to tell the truth.
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The hard truth is that a central bank cannot function without government funding and authority, and cannot be genuinely independent. Most bond investors understand this; however, it has, until recently, been what we might call uncommon knowledge. Things have changed, and the notion of central-bank independence is being openly questioned – primarily in the US, but also increasingly in the UK.
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Fiscal dominance
Donald Trump lives in the public domain. He became a household name via reality TV and conducts public policy via social media. Conventionally, it’s thought that like sausages, government policies are better not seen being made. However, Trump does things differently and since April, has variously referred to his Chair of the Federal Reserve on Truth Social as “Jerome ‘Too Late’ Powell”; “Too Angry, Too Stupid, & Too Political”; “TOTAL LOSER”; “A FOOL”; “Stubborn MORON”; “and “the Worst”.
From a political perspective, what the electorate is witnessing might be the consequence of trying to divert public attention, maybe from the bombing of Iran or the contents of the “Epstein files”. However, the underlying economic driver here is what economists call fiscal dominance. As Ray Bourne, of the Cato Institute, puts it: “Under fiscal dominance, monetary and financial policies get subordinated to support the government’s financing needs, with more tolerance for high inflation... long-term, the graver danger to central bank autonomy isn’t Trump’s tweeting – it’s US politicians’ borrowing.”
In short, beyond the event horizon of out-of-control sovereign debt, accepted rules and market correlations stop functioning. Just like in a black hole where the accepted laws of physics no longer apply, so too in a world of fiscal black holes, the accepted norms of central banking monetary policy stop working. For context, the US federal deficit has increased by $1 trillion, or 2.8%, since the passage of the “big beautiful bill”, and the raising of the debt ceiling last month, and now stands at $37.2 trillion.
The annual campout for the world’s under-siege central bankers in Jackson Hole later this month can’t come soon enough. This year’s theme is “Labour Markets in Transition: Demographics, Productivity, and Macroeconomic Policy”. But between official proceedings, time will be found to discuss the real agenda occupying them: how do we remain independent, or at least appear to be independent, and how can we pretend inflation targeting is even possible in a fiscally dominant world?
While Trump overtly undermines, insults and publicly humiliates his Fed chairman, in the UK, we do things more subtly. This week, both Keir Starmer and Rachel Reeves claimed the Bank’s ambiguous “hawkish cut” decision to lower UK policy rates as evidence of their successful stewardship of the UK economy. It was, they said, all part of their orchestrated plan to put the UK on a more secure economic footing.
Aside from the (lack of) independence point, there are two issues here. First, market interest rates that set the government’s cost of borrowing rose sharply following the BoE decision. UK gilt yields from one-year to 30 years’ duration rose as the bond vigilantes sharpened their axes. Second, the BoE’s governor, Andrew Bailey, said with a straight face that he thought that they needed to cut rates even though he expects inflation to “temporarily increase” to 4% next month. Is this the same as transitory? Note that the UK’s inflation rate has been above target in 48 out of the last 50 months. Sure, the world is getting riskier, but their models are no longer fit for purpose in a fiscally dominant world, nor are their proponents.
The pretence under which the Fed and BoE operate is becoming too obvious to ignore. Their work is increasingly conflicted with their fiscally irresponsible political masters, who can no longer afford for their independent monetary experts to achieve their mandates. So say goodbye to the era of central bank orthodoxy and hello to the new era of central bank dependency. There’s a new boss in town with different ideas. As they might say in Wyoming, inflation ain’t going nowhere. There’s a new sheriff in town, and he kinda likes it.
A version of this article was first published by wealth management group Dowgate Wealth.
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