Is Fiscal Responsibility that Unique? 1.27.26

Growing up, I learned very quickly how to save money and to not live beyond my means.  Having to borrow for college and sometimes work as many as three jobs simultaneously while getting my college degree made me a saver.  I took to heart Benjamin Franklin’s adage, “A penny saved is a penny earned.” And so did the woman I married. When we arrived in Chapel Hill after our honeymoon, we started our life together in a very small cinder block apartment on campus.  Money was tight.  If there was a creative cheap recipe with Bisquick, Elizabeth knew it.  I lovingly referred to her my “Bisquick Queen”.  And many of my classmates in the Business Program were not much better off.  But we knew how to have fun, even with little money – potluck dinners followed by charades was a popular activity for most of us who were married.

One of the simple pleasures that my study group would pursue on Fridays was to have lunch at one of the spots on Franklin Street.  While everyone else ordered off the menu, I would open my brown bag lunch.  I would order a soft drink – that was my treat.  When my classmates would kid me about this, I would say that Elizabeth had me on a strict budget. She was the one putting me through graduate school – so she managed our finances.  Years later, I would still bring a brown bag lunch to work, even though most of the people who worked under me would go out to lunch.  Lynn, my long-time office manager would joke, “That’s how rich people get rich – brown bagging their lunch!”  Like Ben said, “A penny saved is a penny earned.”

Thankfully, I had a successful career that allowed Elizabeth and I to have a fair amount of financial independence.  But I still did not part easily with a dollar.  Elizabeth had to convince me to finally buy a semi-luxury car – an Accura.  And my financial advisor would constantly remind me that I was living “below my means.”  And I would say, “And your point is…” So, now that I have established that I am a fiscal conservative, I have something to say about the future of interest rates, the current administration, and our country’s finances in general. The following is an excerpt from my company’s January 2026 Market Update.

The past 4 years have been a doozy. Due to supply chain disruptions and government actions in response to COVID, the United States experienced hyper-inflation in 2021 and 2022. As a result, the Fed raised the target for the Fed Funds Rate by a record 425 basis points in 2022. And raised short term rates an additional 100 basis points in 2023, resulting in a Fed Funds target of 5.5%, up from 0.25% in 2021.  The Fed was intent on bringing inflation under control.

With inflation finally moderating to an average of 2.9% in 2024, down significantly from 8.0% 6.5% and 4.1% in 2021, 2022 and 2023 respectively, there was tremendous pressure for the Fed to reduce the target for the Fed Funds target in early 2024. However, not convinced that inflation had moderated, the Fed waited until September of 2024 to begin cutting interest rates, doing so three times, lowering the Fed Funds target from 5.5% to 4.5%. 

When Trump took office at the beginning of 2025, he began criticizing Fed Chairman Jerome Powell and the Fed for being too restrictive with monetary policy.  However, one of the major reasons the Fed decided to wait to lower rates was see how the tariffs that the Trump Administration had announced would impact the price of goods – there was a widely held belief that Trump’s exorbitant tariffs would ignite inflation. 

Two things have occurred since then.  Trump’s tariffs were less than originally announced and oddly enough, the tariffs that were put in place have not put upward pressure on prices – at least not yet.  So, with inflation stabilizing between 2.3% and 3.0% during most of 2025, the Fed made three more rounds of cuts at the end of 2025, with the Fed Funds target currently standing at 3.75%.

And it looks like the Fed has accomplished a soft economic landing, something many economists doubted when the Fed began cutting interest rates in 2024. In our January 2023 Market Update, we explain what a “soft landing” is.  This is where the Fed tries to get the economy to a healthier inflation rate of 2% to 3% while maintaining close to full employment and positive GDP growth. This is very difficult to do without avoiding a recession.  But remarkably, the Fed seems to have done so.

So, for those of you not familiar with monetary policy, the central bank, also referred to as the Federal Reserve sets short-term borrowing rates between banks. This is known as the targeted Fed Funds rate.  When the Fed wants to stimulate the economy by lowering borrowing costs for everyone, it will lower the Fed Funds target.  Long-term borrowing costs usually follow, lowering the costs for mortgage debt, college loans, car loans, and corporate debt securities.  And there is something called the interest rate yield curve that explains this relationship between short-term and long-term interest rates. But even though the Fed cut interest rates in late 2024 and into 2025, long rates did not go down – they went up!  In other words, the “Yield Curve” became steeper, meaning that the difference between short-term and long-term interest rates increased because investors were still concerned about long term inflation.  And when long term taxable rates go up, borrowing costs go up for everyone.

Many economists expected some steepening of the yield curve. A positive spread between short-term and long-term rates, as we now have, indicates a “normal” curve, where long-term investors demand higher returns for increased risk. In contrast, the market experienced a deep, prolonged “inverted yield curve” between 2022 and 2024, which is not normal.  In fact, the inverted yield curve we had during that period is the longest on record. This was due in part to the bond market expecting a recession because of a lack of confidence in the Fed’s ability to eliminate high inflation without putting the economy into a recession.  But, as pointed out earlier, the Fed seems to have pulled a rabbit out of the hat.

Now that the Fed has managed to create a soft economic landing, its mandate for 2026 will be to create an interest rate environment that neither stimulates nor restricts economic activity – in other words – neutral. Strong economic growth will cause the Fed to stay the course. Weak job growth will cause the Fed to cut rates further.  But two factors could change the Fed’s ability to influence long term rates.  One has to do with maintaining central bank independence and the other has to do with investors’ trust in U.S treasuries as a safe haven.

Central Bank Independence – Concerned about the mid-term elections, the Trump administration this past year has been harassing the Fed Reserve to cut interest rates more aggressively. If unemployment rises or the economy slows down significantly, Trump believes republican congressmen will be blamed and will lose their seats, flipping the House to the Democrats. For this and other reasons, the White House wants to create a “Red Hot” economy. Most economists will tell you that doing so may be good in the short run but is terrible fiscal policy in the long run because it could create hyper-inflation.  And some argue that once inflation takes hold, it is like a bad virus that is hard to eliminate.  It becomes chronic.  Hence the reason the Fed took such drastic measures in 2022 and 2023 to reign in high inflation. 

Like Presidents before him, Trump is not necessarily concerned with the long run.  And so, as a backdrop to all of this, the President is trying to reduce the independence of the Federal Reserve by using coercion and intimidation tactics to influence. This is not the first time presidents have tried to influence the Federal Reserve on monetary policy.  Before the run-up to the 1972 election, President Nixon pressured then Fed Chairman Burns to engage in “expansion monetary policy.” In other words, to cut interest rates, which led to a decade of high inflation and other economic problems. Because of that incident, the independence of the Federal Reserve has been fiercely guarded. So, we have an independent Federal Reserve that uses fact-based evidence and economic conditions to set interest rate policy without being influenced by political pressure and intimidation. And it has an admirable track record of maintaining the proper balance of full employment and low inflation. 

To intimidate the Federal Reserve even further, Trump decided to use the Justice Department to indict Fed Chairman Jerome Powell with no evidence of wrongdoing. This is the first time in its 112 history that the Federal Reserve’s Chairman has been indicted on charges of wrongdoing while holding the office.  Jerome Powell did not sit back.  He made a very eloquent and powerful rebuttal of the President’s attempt to influence the Federal Reserve.

Based on oral arguments presented to the Supreme Court this week, it looks like the Court will block Trump’s attempt to remove Cook, another member of the central bank, signaling a defense of the central bank’s independence. Justice Kavanaugh, a conservative and Trump appointee, highlighted the long history and economic impetus of shielding monetary policy from White House control. “The Trump administration’s claims of broad and unreviewable firing authority “would weaken, if not shatter, the independence of the Federal Reserve,” Kavanaugh warned. “Thinking big picture, what goes around comes around,” Kavanaugh said. “History is a pretty good guide. Once these tools are unleashed, they are used by both sides.” 

Because of tremendous backlash to Trump’s efforts to influence monetary policy and pump-prime the economy before the mid-term elections, and the Supreme Court’s decision to keep the central bank independent, we believe that our economy has avoided, for now, that Black Swan event.  However, there is another nagging issue on the horizon that could hinder the Fed’s ability to control long term interest rates in the future – another possible black swan event – what happens if the world stops believing that U.S. treasuries are a safe-haven and stops buying U.S. Debt. Could it be that the current yield curve steepening reflects fiscal strain and long-term policy credibility rather than pure growth optimism?  

Interest payments by the Federal Government—expected to approach 1 trillion a year—remain the fastest-growing part of the federal budget. Most economist agree that when a country’s total debt exceeds 80% of its GDP, it is difficult to create economic growth because government debt crowds out private investment. The United States is now at 125%.  Here is where the United States stands now. We have a large structural fiscal deficit, a savings rate near zero and a reliance on the goodwill of investors to fund an explosive increase in debt issuance.

The United States recently sold $654 Billion of federal debt. The yields on long-term bonds refused to come down, even with three recent Fed cuts. As pointed out earlier, long-term treasuries set the long-term borrowing costs for mortgage debt, college loans, car loans, and corporate debt securities. This is a problem if you are headed into a recession and you cannot get long-term rates to go lower. That phenomenon is called “stagflation.” It happened from 1973 to 1982.  Remember the Nixon incident?

“The Fed may want lower interest rates, but the market ain’t buying it,” said Willian Adler, a very well respected technical market analyst with Elliott Wave International. The firm bases much of its macroeconomic research on the book, The Socionomic Theory of Finance, regarded as one of the most insightful books written on economic theory.

He asserts that we could be headed to a bond rout if our current trajectory does not change. The current yield may simply reflect fears of resurgent inflation as stimulus from the “one big, beautiful bill” stimulates the economy over the coming months.  Or this could the first sign that America is starting to pay a price for the collapse of political credibility and poor financial policy.

The US treasury had to sell $30 trillion of federal debt last year, either in the form of “rollovers on old debt” or in new issuance. This is 100% of GDP or five times the normal “danger line” monitored by rating agencies. The comparable figure is 31% for Japan, 19% for France, 16% for Italy and 10% for the UK.  You may be wondering, “how can the United States have this high level of debt?” 

Because the world sees U.S. Treasuries as a safe-haven, the US dollar serves as the world’s reserve currency, and this distorts the picture. Companies and funds all over the world use US Treasury bills as quasi-cash, a liquid safe asset for parking money, and this keeps our cost of borrowing artificially low. However, what would happen if the world started to use digital tokens linked to gold or a basket of commodities and global currencies as alternatives?

The fragility of the bond market is currently being disguised by the current treasury secretary by raising money through short-term bills to take the strain off of long-term bonds, lifting the share of short-term bills to 40% to 50% of the monthly issuance, against the advice of the treasury watchdog that it should not exceed 20%.

When one of my clients is about to borrow, the client sometimes obtains a credit rating. One factor that goes into the rating analysis is the debt structure itself. Rating agencies believe (in general) that a non-profit should have no more that 30% of its debt as short-term variable rate debt because doing so exposes the organization to too much interest rate risk and “put” risk.  This theory goes out the window if the borrower is sitting on a pile of cash. The United States is not sitting on a pile of cash.

Having almost 50% of our debt structured as short-term bills is a perilous game. The longer it goes on, the greater the rollover risk or put risk. And if global investors begin to lose faith in our country’s ability to service its debt or begin to see geopolitical risk in how we conduct ourselves on the world stage, investors may begin to use other avenues to park cash. This can cause long-term interest rates to remain stubbornly high or even go up. Trump’s continued desire to take away the central bank’s independence or a loss of global confidence in U.S. treasuries are Black Swan events that can make everyone’s forecast for long-term interest rates meaningless. 

Warren Buffet, widely considered the most successful investor of the 20^th century is quoted as saying, “It takes 20 years to build a reputation and five minutes to ruin it.” If that is true, the United States is in grave danger of losing the goodwill of investors that has been built over generations to fund the United States explosive increase in debt. Personally, I am optimistic that we can hold onto that goodwill long enough to correct our current path. So, what will 2026 look like from an interest rate standpoint? Hold on to your seats – it could be a wild ride….

The United States is not the only country with too much debt. Just last week, Japanese bonds crashed, sending tremors through global financial markets – traders were still stunned by the speed and breadth of it all.  Inflation, long dormant in Japan, has taken hold and, moreover, the Japanese Prime Minister is pushing fiscal stimulus plans that would swell government debt further.  As a result, investors have been frantically sending bond yields up to levels once unthinkable. That’s exerting upward pressure on interest rates in countries like the U.S. Britain and Germany.

An even bigger worry for global markets over the long term is that the new normal of higher Japanese yields will prompt Japanese investors to bring much more of their money back home. Some $5 trillion of the country’s capital is deployed overseas, much of it in the U.S.  So, the possibility of an exodus of money out of U.S. treasuries is not as far-fetched as one might think.   I am hopeful that at some point our country will develop the political will power to actually practice fiscal responsibility.  Is fiscal responsibility that unique?