The Fed's Challenge: Walking the Tightrope

Tariffs have dominated the headlines, but the national debt is the critical issue that will define our future, says Thomas Hoenig. As a member of the Federal Open Market Committee (FOMC) from 1991-2011, Tom is well known in monetary circles for his stand against extending the Federal Reserve (Fed)’s easy-money policies following the Great Financial Crisis—casting the longest run of “no” votes in the central bank’s history.

Then as now, Tom’s focus is on the fundamentals and the long-term consequences of policy decisions. In our latest webinar, he shared his clear-eyed perspective on the current health of the U.S. economy, the Fed’s decision-making process and the forces currently complicating policymakers’ decisions.

Listen to our conversation and read key takeaways below.

Key Takeaways

Edited excerpts from our conversation with Thomas Hoenig.

Trillion-Dollar Debt Trumps Tariffs

The long-term, essential issue for the United States that is being pushed aside for the moment is our fiscal standing. We are creating enormous amounts of debt each year. We have almost a $37 trillion debt. Right now, we're running a $2 trillion deficit that cannot go on. Yet, we're still arguing about how much we'll let the deficit be next year rather than how we'll bring that debt down … Tariff policy, as it’s being played now, is very important because it's affecting behavior. But in the long run, our debt will define our future.

Does Uncertainty Tip the U.S. Into a Slowdown?

The idea of uncertainty has grown in importance. Usually, you look at surveys measuring confidence, and you move on. But now, we're paying more attention to uncertainty, and the Fed is, too. Small-business confidence is down, and consumer confidence is down. And that is clearly related to tariffs because tariffs are basically a tax on the consumer. How those tariffs are administered will affect their choices and the allocation of spending across the economy.

Wait, the Fed Eased on March 19?

The real message from the last meeting was, “We're going to slow down a little bit. We're really waiting to see.” The other thing the Fed did at the meeting, which didn't get a lot of attention, was pull back on shrinking their balance sheet or the so-called quantitative tightening. [Chair Jerome] Powell said it wasn't an easing. I say it was. It leaves liquidity in the market that otherwise wouldn't be there.

Government Inaction Puts Pressure on the Fed

Let's round and say a third of our national debt has to be refinanced. That’s about $10 trillion. On top of that, you have $2 trillion of new debt that has to be sold. Does the rest of the world want to buy all our debt? Do they like doing that all the time? No. That leaves it to the private sector in the United States—banks, individual investors, pensions. How are you going to incent them to buy your bonds if you're the government? Higher rates.

And if the bond vigilantes* and the public say we're not really addressing the debt—I know DOGE [Department of Government Efficiency] can have some impact, but it's going to be minor compared to the size of the debt—then we're going to have to finance that. You'll see 10-year Treasury rates start to come back up, and that's when the real pressure on the Fed starts to apply because the whole yield curve shifts up. This is going to slow the economy. It puts pressure on them to ease so that the banks can hold more of that debt and still finance the private sector. That's what I think will be a major issue.

Our National Debt Is Not Free

People don't understand that our national debt is not free. It precipitates excess demand in the economy because the government competes with the private sector, which puts pressure on the Fed to print more money. Then the money supply grows, and inflation grows. That's why people are unhappy: they look at how much more they're paying for goods today than four years ago. High inflation also affects our ability to compete internationally.

Cost of Capital Needs to Normalize

The fact of the matter is that in this country, for almost two decades, the cost of capital has been arbitrarily repressed. Pushed down in the mistaken belief that increasing asset values will save the day or it won't cause that much inflation—it’s worth it.

If the Fed is doing its job for the long term, I would expect the cost of capital to come back up to a more reasonable, historically adjusted level where resources are allocated appropriately based on the real, relative cost of capital. And that’s going to shake things up. Looking back over the last two decades, the financial system has grown as a percent of GDP [gross domestic product] because it's been arbitrarily subsidized by the Fed and the federal government. So, we need to see some normalization of the cost of capital that will do us all better in the long run. Now, if you're in the short-run business, you're a trader, you won't want to hear that.

What the Fed and the Government Can Do

The way they're doing tariffs is not revenue-oriented. It's more punishment-oriented for those we trade with because we think we're being taken advantage of. But the real fact of the matter is if we addressed our long-term problems, then I think the issues around tariffs would be much less because the relative tariff among countries is not as great as the picture being painted about them.

So, I wish we would turn our attention to addressing the debt. That's really painful because you can't address this debt without addressing things like entitlements, and that's why it's so hard to do. No one is willing to step up to it, and the public doesn't want to pay the price.

One of the things the Fed would have to say is, "We're not going to support this growth in the debt." That means we're going to allow interest rates to rise more than you would like and more than many expect. And that means the Fed will be under enormous pressure—from the administration, from Congress and from the public—because that will slow the economy.

It Can Be Done. We’ve Done It Before

We've done it in the past in very difficult times. I remind people that in the mid-90s, with a Democratic president and Republican Congress—Newt Gingrich in the Congress and Bill Clinton in the presidency—we had a deficit problem, and the bond vigilantes were active.

But they came together and developed budget legislation that over time was designed to reduce the debt. I think their plan was for seven years. They cut some expenditures, especially in the entitlement system, they raised some taxes, and they stuck to their agreement. Over the next four years, the United States went from an annual deficit to a surplus. That was the first time they'd done that in decades. But they did it.

Here's the important point. The effects were that people felt confident that we were addressing it [the deficit] so productivity went up, and our real gross domestic product had increases of 4% a year. We haven't seen that. We're projecting 1.7%.

Congress and this presidency need to take their eye off the tariff ball and put the debt as the main issue. Yes, they can use tariffs if they want to raise revenue—make them across the board and know why they’re doing them—then you can solve some of this debt and deficit problem. I think the economy would take off, be more productive and we'd have a very good investment environment for everyone. That's possible, but I can't help but note that at the State of the Union message, one side of the room never stood up, and the other never sat down.

We have to get that to work.