Former New York Fed Chair Dudley warns: If the independence of the Federal Reserve is compromised, unsustainable fiscal policies could trigger a backlash in the bond market.

Former President of the New York Fed, Dudley, warned in an article that the fiscal outlook of the United States is deteriorating. According to the Congressional Budget Office (CBO) forecasts, the annual fiscal deficit of the United States for the next decade will reach about 6% of GDP, and the federal debt ratio will also rise to historic highs. Dudley pointed out that against the backdrop of worsening fiscal conditions, if the independence of the Federal Reserve is weakened and forced to maintain low interest rates, the United States may face higher inflation and interest rate risks, and even trigger a financial crisis. Structural factors are deteriorating the US fiscal situation The article points out that multiple long-term structural factors are having a profound impact on the fiscal situation of the United States. Firstly, the pressure of aging population is increasing. As the Baby Boomer generation gradually retires, Social Security and Medicare expenditures will significantly increase. At the same time, tightening immigration policies and declining birth rates mean that labor force growth is stagnating, weakening the tax base. Secondly, fiscal policy itself is expanding the deficit. Last year's passage of the "One Big Beautiful Bill Act" significantly reduced corporate and individual income taxes. The CBO estimates that this act will increase the US fiscal deficit by about $4.7 trillion over the next decade. Revenue from tariffs difficult to fill fiscal gap Although the CBO previously estimated that increasing tariffs could generate about $3 trillion in revenue over the next decade, this forecast is highly uncertain. The Supreme Court has ruled that tariffs imposed under the International Emergency Economic Powers Act (IEEPA) are illegal and have ordered the refund of related taxes. This means that previous revenue expectations may have been overly optimistic. At the same time, the Trump administration is trying to offset tax revenue losses through new tariff policies, but the legal authority available is limited. For example, the comprehensive tariffs imposed under section 122 of the Trade Expansion Act can only last for 150 days unless extended by Congress. Defense spending and war costs may be underestimated Dudley also believes that CBO's forecast of future defense spending may be too low. Even before the outbreak of the Iran war, the Trump administration had proposed to increase the defense budget for the fiscal year 2027 from $893 billion in fiscal year 2025 to $1.5 trillion. However, CBO's baseline projection assumes that expenditures in 2027 will increase by about 1% compared to 2025. In addition, military conflicts could result in significant additional costs. The Center for Strategic and International Studies estimates that a war with Iran could cost the US about $1 billion per day. Interest on debt becoming a new source of fiscal pressure As the deficit continues to expand, the US government's debt servicing costs are rising rapidly. CBO projects that federal government interest payments as a percentage of GDP will increase from 3.3% in 2026 to 4.6% in 2036. At the same time, a large amount of low-interest debt issued between 2009 and 2022 is maturing, requiring refinancing at higher rates, further increasing the fiscal burden. Dudley believes that this is also an important reason why the Trump administration is trying to influence Federal Reserve policy and keep interest rates low. Even with increases in inflation, problems are difficult to solve The CBO forecasts that the nominal GDP growth rate in the US for the next decade will be around 4%, while the fiscal deficit as a percentage of GDP will be about 6%. This means that the share of federal debt in GDP may increase by about 2 percentage points each year. Even if economic growth and inflation each increase by 1 percentage point, bringing nominal GDP growth to 6%, fiscal pressures are still unlikely to be completely relieved. On one hand, accelerating economic growth is often difficult to sustain long-term; on the other hand, if inflation rises and the independence of the Federal Reserve is compromised, inflation expectations may rise, pushing up long-term bond yields and increasing government financing costs. Markets may ultimately force policy changes Dudley concludes by warning that the current market seems to ignore the unsustainability of the US fiscal path and the lack of political will to address it. He quotes economist Herbert Stein, saying, "If something cannot go on forever, it will stop." Once the independence of the Federal Reserve is compromised, it may trigger the re-emergence of the bond market "watchdog," causing financial market turmoil and ultimately forcing the government and Congress to adjust fiscal policy.