The Stage is Set: Familiar Playbook, Different Starting Point
As President-elect Trump prepares for his second term, we are entering a period that bears striking similarities to 2016, but with crucial differences.
Back then, I wrote about how Trump’s fiscal expansion plans, combined with the Federal Reserve’s willingness to tolerate higher inflation, created a unique alignment of fiscal and monetary policy. Markets reflected this dynamic, with rising inflation expectations and strong equity performance. See here and here.
Now, the stage appears set for a repeat performance—or at least a variation on the theme. Trump’s vocal opposition to debt ceiling constraints (see his post on ‘Truth Social’ from yesterday below) suggests that fiscal policy will again tilt towards expansion.
While details remain unclear, tax cuts and a push for deregulation seem likely to feature prominently (and higher tariffs). This aligns with the fiscal playbook of Trump’s first term, though the environment today is much less forgiving.
The Fed’s New Context
Yesterday, the Federal Reserve cut rates by 25 basis points, bringing the federal funds rate to 4.25-4.5%. However, their projections for 2025 signal a more restrained approach, with fewer rate cuts than previously anticipated.
Inflation remains above target, and Powell’s Fed is keenly focused on maintaining its credibility. This stands in stark contrast to the Fed of 2016, which welcomed fiscal stimulus as a way to lift inflation closer to its target.
This is clearly illustrated in the graph below – back in 2016 inflation expectations were well-below the Fed’s 2% inflation target. Today, we are closer to 2.5% inflation – hence slightly above the inflation target.
The Bond Market Speaks
The bond market is already reflecting this tension. The 10-year Treasury yield yesterday rose to 4.5%, but inflation expectations have remained largely flat.
This suggests that markets believe any inflationary impulse from fiscal policy will be neutralised by the Fed’s actions. Rising real yields, rather than nominal ones, are driving this dynamic—a clear sign that monetary policy will act as a counterweight to fiscal expansion.
Why 2024-25 Is Not 2016
In 2016, fiscal and monetary policies worked in tandem to boost below-target inflation and support nominal growth. Today, however, we begin from a situation with elevated inflation and higher rates. This changes the entire framework for how fiscal and monetary policies interact.
As Trump’s fiscal plans become clearer, the interplay between fiscal ambitions and the Fed’s inflation mandate will define the economic landscape. The market reaction so far underscores the limits of fiscal policy in a world where monetary vigilance remains paramount.
The Fed’s Balancing Act
The Federal Reserve’s rate cut yesterday, bringing the federal funds rate to 4.25-4.5%, underscores the central bank’s cautious approach to managing a challenging environment.
Unlike in 2016, when fiscal expansion and monetary accommodation worked in harmony, the Fed now faces a very different scenario. Inflation remains above target, and Powell’s primary focus is to ensure price stability while carefully navigating the pressures of fiscal expansion.
What’s particularly striking is the Fed’s revised outlook for 2025. By reducing projected rate cuts from four to two, the Fed has sent a clear signal that its easing cycle will be far more constrained than markets might have anticipated.
This adjustment reflects hard-learned lessons about inflation dynamics and suggests a central bank unwilling to repeat the mistakes of the 1970s, when monetary policy succumbed to fiscal pressures.
The Shadow of Fiscal Expansion
The potential for further fiscal expansion under President-elect Trump (or at least lack of fiscal consolidation) adds another layer of complexity. Trump’s remarks about the debt ceiling and his administration’s likely push for tax cuts signal a return to fiscal looseness. However, the Fed’s stance indicates it will not allow these policies to undermine its inflation-fighting credibility.
This reflects the essence of the so-called Sumner Critique: fiscal policy cannot sustainably drive aggregate demand if the central bank is committed to its nominal target. Powell’s Fed, by maintaining its focus on inflation stability, is ensuring that fiscal expansion under Trump will be met with monetary discipline.
Unlike in Trump’s first term, the Fed’s monetary stance is now operating from a position of relative high and maybe even rsing real rates. This means then Fed must walk a fine line, easing just enough to support the economy while ensuring that fiscal-driven inflation pressures remain firmly under control.
Markets Anticipate Monetary Restraint
The bond market’s reaction confirms this interpretation. While 10-year yields surged yesterday, inflation expectations have remained flat. This stability signals that investors trust Powell to counteract any inflationary impulses from fiscal policy. Instead, the rise in real yields is driving tighter financial conditions, adding downward pressure on equity markets.
The Fed’s Independence on Trial
The current environment places Jerome Powell’s leadership in sharp relief. The Fed’s independence has long been tested by political pressures, from Nixon’s influence on Arthur Burns in the 1970s to Trump’s public critiques during his first term. Powell’s cautious stance suggests he is determined to avoid the mistakes of the past, prioritising the Fed’s credibility even as fiscal ambitions grow.
As fiscal plans take shape, the Fed’s ability to manage this delicate balance will be crucial. Markets are already pricing in a central bank that is prepared to stand firm—a dynamic that will shape the interplay between monetary and fiscal policy in the months ahead.
Equity Markets Adjust to Real Yields
The rise in real yields has also filtered through to equity markets, contributing to the broad sell-off. Higher real yields increase the discount rate applied to future corporate earnings, reducing valuations and driving stocks lower.
Following the revised Federal Reserve outlook, the Dow Jones Industrial Average plummeted 1,123.03 points, or 2.58%, to close at 42,326.87. This marked the index’s 10th consecutive day of decline, its longest losing streak since 1974, and set it on course for its worst weekly performance since March 2023.
Meanwhile, the S&P 500 dropped 2.95% to 5,872.16, and the Nasdaq Composite sank 3.56% to 19,392.69, with losses in the tech-heavy index accelerating toward the end of the trading session.
Both the Dow and the S&P 500 recorded their largest single-day declines since August, a period marked by market turbulence triggered by the unwinding of the yen carry trade.
The Fed’s Path Forward
Markets are now pricing in a scenario where fiscal expansion will face firm limits imposed by monetary policy.
Over the past month, there has been a significant shift in market expectations for interest rate movements in 2025, as reflected in the CME FedWatch Tool (see below).
While the market previously anticipated deeper rate cuts below the 375-400 basis point range, expectations have now become more restrained. The dominant probability now centers around the 400-425 basis point range, signaling a forecast of gradual and moderate easing rather than aggressive rate cuts.
This shift aligns with FOMC statement, which highlighted solid economic growth and continued, albeit slow, progress toward the 2% inflation target.
Although inflationary pressures are easing and the labor market is showing some signs of cooling, the Fed emphasized ongoing economic uncertainty, limiting the likelihood of swift and substantial easing. As a result, the market has adjusted its outlook, anticipating a more cautious approach from the Fed, driven by data and balanced risk assessments.
Bessent’s “3-3-3” Framework Faces Reality
The nomination of Scott Bessent as Treasury Secretary adds a twist to this equation.
His “3-3-3” framework—targeting 3% growth, a 3% deficit, and increased oil production—presents a vision of fiscal responsibility that conflicts with Trump’s clear preference for aggressive fiscal measures.
Markets are already questioning the credibility of Bessent’s framework, particularly in light of Trump’s dismissive comments about debt ceilings.
This tension between the Treasury’s stated goals and Trump’s fiscal instincts further complicates the policy landscape. The Fed, however, remains the ultimate arbiter of aggregate demand, and Powell’s cautious stance ensures that any fiscal expansion will face meaningful limits.
Lessons from Historical Misalignments
The parallels to historical episodes of fiscal-monetary misalignment are clear. The Bundesbank’s reaction to German reunification in the early 1990s provides a particularly relevant example. Faced with massive fiscal expansion, the Bundesbank tightened monetary policy aggressively to maintain price stability, even at the cost of a sharp economic slowdown. See more on this here.
Today, Powell’s Fed faces a similarly challenging environment, though its tools differ. Instead of raising rates aggressively, Powell may demonstrate monetary restraint through a slower-than-expected pace of rate cuts.
The Political Tensions of Fiscal and Monetary Policy
The dynamics between fiscal and monetary policy are not just economic; they are inherently political.
President-elect Trump’s fiscal ambitions, as evidenced by his dismissive remarks about debt ceilings and focus on tax cuts, could bring renewed political pressure on the Federal Reserve.
This recalls the 1970s, when President Nixon famously pressured Fed Chair Arthur Burns to loosen monetary policy to support his fiscal agenda—a decision that ultimately undermined inflation control and the Fed’s credibility. I have written about the this unfortunate episode in US monetary policy before – see here.
Jerome Powell, however, appears determined to avoid such pitfalls. His leadership of the Fed has consistently emphasised independence and a commitment to price stability.
Powell’s resolve surely will be tested, but his actions so far indicate that he is unlikely to repeat the mistakes of the past, but that might ultimately end in a major confrontation with the Trump administration.
Trump’s populist Keynesianism will test the Fed’s independence, while Powell’s cautious approach will likely frustrate those expecting rapid monetary accommodation.
This emerging dynamic highlights the fundamental constraint on fiscal policy: the central bank’s commitment to price stability. As in the past, monetary policy will dominate fiscal outcomes, ensuring that any fiscal expansion operates within the boundaries set by the Fed.
Trump will only win the battle against Powell’s commitment to price stability is Powell is replaced by a Arthur Burns type central bankers. Lets not hope it comes to that.
The Sumner Critique in Practice
The unfolding situation serves as a real-world demonstration of the Sumner Critique. Fiscal policy, however ambitious, cannot sustainably boost aggregate demand if the central bank is committed to its nominal target. Powell’s cautious approach, coupled with the Fed’s measured pace of rate cuts, ensures that fiscal expansion will not lead to runaway inflation or unanchored expectations.
The Bottom Line
The months ahead will provide a critical test of the balance between fiscal ambitions and monetary discipline. The Fed’s cautious approach, combined with the market’s clear signals, reinforces the limits of fiscal policy in a world of vigilant monetary oversight.
As I have long argued, monetary policy ultimately dominates fiscal policy in determining nominal outcomes. Powell’s Fed seems prepared to uphold this principle, ensuring that monetary credibility remains intact even in the face of aggressive fiscal measures. The market reaction so far tells us the story: fiscal policy will not run unchecked, and the Fed will remain the anchor of nominal stability.
Note: The illustration above was created with fal.ai/FLUX.
PS: I want to acknowledge that my use of the term “Keynesian” here may not align with how serious (New) Keynesians would define their approach. In this context, I use “Keynesian” to describe the type of demand management policies that proved problematic in the 1970s. While these policies were inspired by Keynesian economic thought and can be labeled as such, this does not imply that modern Keynesians would necessarily endorse or agree with these strategies. I might also have used the term vulgar supply side economics.
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