With federal debt at high levels, raising interest rates creates a massive fiscal transfer. The government's interest expense, now over a trillion dollars, becomes income for bondholders. This stimulatory effect for the wealthy can counteract the intended tightening, while simultaneously hurting lower-income individuals who need to borrow.
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While necessary to refinance national debt, lowering interest rates has a severe side effect: it fuels a "K-shaped" economy. The resulting inflation enriches those who own assets like stocks and real estate while simultaneously punishing wage earners and savers, thus widening the wealth gap.
Recent inflation was primarily driven by fiscal spending, not the bank-lending credit booms of the 1970s. The Fed’s main tool—raising interest rates—is designed to curb bank lending. This creates a mismatch where the Fed is slowing the private sector to counteract a problem created by the public sector.
When national debt grows too large, an economy enters "fiscal dominance." The central bank loses its ability to manage the economy, as raising rates causes hyperinflation to cover debt payments while lowering them creates massive asset bubbles, leaving no good options.
Deficit spending acts as a hidden tax via inflation. This tax disproportionately harms those without assets while benefiting the small percentage of the population owning assets like stocks and real estate. Therefore, supporting deficit spending is an active choice to make the rich richer and the poor poorer.
Due to massive government debt, the Fed's tools work paradoxically. Raising rates increases the deficit via higher interest payments, which is stimulative. Cutting rates is also inherently stimulative. The Fed is no longer controlling inflation but merely choosing the path through which it occurs.
The Federal Reserve faces "fiscal dominance," where government debt dictates monetary policy. With a massive amount of US debt maturing in 2026, the Fed will be forced to lower interest rates to make refinancing manageable, regardless of other economic indicators. The alternative is national insolvency.
The Fed's tool of raising interest rates is designed to slow bank lending. However, when inflation is driven by massive government deficits, this tool backfires. Higher rates increase the government's interest payments, forcing it to cover a larger deficit, which can lead to more money printing—the root cause of the inflation in the first place.
The massive increase in government debt held privately has broken the monetary policy transmission mechanism. When the Fed raises rates, the private sector's interest income from Treasury holdings now rises significantly, creating a stimulus that counteracts the tightening effect on borrowing costs.
Higher interest rates on government debt are creating a significant income stream for seniors, who hold a large amount of cash-like assets. This cohort's increased spending power—either for themselves or passed down to younger generations—acts as a counterintuitive fiscal stimulus, offsetting the intended tightening effects of the Fed's policy.
High debt and deficits limit policymakers' options. Central banks may face pressure to absorb government debt issuance, which conflicts with the goal of raising interest rates to curb inflation, leading to a new era of "fiscal dominance."
