The Case for Lower Rates and Inflation

September 2026

By Saki Bigio

The Federal Reserve and this Administration's Treasury are on a collision trajectory, clearly traced by the yield curve: while the short end is pinned exactly where the Fed wants it, the long end keeps spiking. Bond markets are uneasy, and for only one reason: they anticipate that future inflation will be necessary to finance the Treasury's debt. Modern macroeconomic doctrine has a ready prescription for moments when expectations about future inflation run high: fight the inflation scare now by raising rates. The idea is to signal resolve and defiance of an administration's pressures. Doing so is the way to "anchor" inflation expectations. This dogma is dubbed the Taylor principle. I think this prescription is misguided and that the Fed should do quite the opposite: lower rates and front-load inflation into the present. And it should do so today. Let me articulate why with three arguments.

The fiscal diagnosis

Before I jump to my arguments, let's start with the fiscal facts. The United States is running deficits unprecedented in peacetime—defining peacetime as no-troops-on-the-ground. I think we can discard supply factors such as oil prices—if supply constraints were the story, one would have to explain why, after decades of dormancy, the anticipation of supply-side constraints suddenly matters. Moreover, the same problem is showing up in Japan, in the United Kingdom, but not in fiscally sound Switzerland. The rise at the long end of the curve tells us that markets have finally awoken to what fiscal arithmetic has long implied: the debt trajectory in many countries is unsustainable, taxes take time to react, and expenses show no sign of correction. Many observers—I am one of them—have concluded that current debt will ultimately be paid in one of two coins: voluntary inflation, or a far costlier one, involuntary inflation. Long rates are simply pricing that conclusion.

#1 rate hikes are futile

Given the fiscal diagnosis, should the Fed then reach for the standard Taylor playbook and hike short-term rates? The problem is that raising rates without any commitment from the Treasury to restrain deficits cannot resolve anything. The first argument is that hiking is worse than futile; it is self-defeating. When markets wake up and do the fiscal math, they discover that a future Fed will have to render the debt sustainable by voluntarily surrendering to the Treasury and inflate debt away, or await an even uglier endgame. Push the tug of war far enough and the Treasury may struggle to place its debt in the primary market. At that point the Fed will face a choice that is not really a choice: it will be forced to absorb the Treasury's debt, bloating its balance sheet continuously. This scenario is akin to direct financing with monetary emissions. Ultimately, this leads to involuntary inflation.

The Taylor principle tells you to raise rates if inflation expectations get out of control for nonfundamental reasons. Here, we are talking about fundamentals: when the public anticipates inflationary finance, the level of debt itself drags inflation expectations upward, because markets know that one way or the other, inflation will have to do the job of stabilizing debt. In this context, every rate hike works against its own purpose: it may cool demand on impact, but it adds more interest payments to the bill, steepening the debt trajectory, and thereby feeding the very expectations it was meant to suppress. Disinflation succeeds for a moment because higher rates cool down the economy, but inflation will resurge with full force if you put debt on a steeper trajectory. Thus, even if higher rates can slow an AI-fueled boom, without a resolution of the fiscal problem there will be only a temporary remission. The mechanism deserves a name: sticky inflation. I think this is a battle the Fed cannot win, and the costs of waging war may be extreme—at least a war fought on this flank.

#2 inflation disciplines politicians

The second argument is that the canon is oblivious to political economy. Inflation, well explained to the public, disciplines politicians: it is a very unpopular tax. Governments rarely survive inflation bursts at the polls. By contrast, politicians love carrying over debt precisely because it does the opposite: it passes the hot potato to the next administration. Raising rates amid an AIbooming economy, while quietly placing the debt on a steeper path, grants them exactly what they like: postponing the political bill. If the Fed truly wishes to demonstrate resolve, it should direct that resolve at the actual source of the problem: make the authors of fiscal excess pay for it, now, in the currency politicians fear most— voters angry with the price of eggs. For that, the Fed should lower rates and provoke inflation. And it should do so while communicating that it is forced to raise its inflation target for as long as deficits last, because it is the only way to respect its mandate in the long term.

#3 it is better to smooth inflation

The third argument is normative. A classic lesson in public finance: it is better to smoothly increase taxes than doing so violently. If inflation is how the debt will ultimately be financed—and the long end of the curve says so—then the question is not whether to have the inflation tax at all, but how to spread it out over time. Concentrating it in a future burst is the worst scenario. Spreading it out—beginning today, withdrawing it as the fiscal accounts are put in order—is what any theory of taxation prescribes. Pretending instead that resolve can suppress the inflation is pretending that the Fed knows better than markets. It does not. Markets understand that losses in a scenario where the Treasury cannot place its debt are too high, and the Fed will come to the rescue. Long rates will stay stubborn because the market can do the arithmetic: sooner or later, inflation, voluntary or not, will pay for our current debt.

Is all of this heresy?

No. Nothing here requires exotic theory. This is what the New Keynesian model prescribes—the very framework central banks use to project inflation—once one feeds it the single ingredient we have been talking about: the anticipation of a fiscal-inflation episode linked to debt. In that model, the optimal response to a fiscal shock is to depart from the Taylor principle, hold real rates persistently low, and front-load inflation into the present. All this math is put together in my recent work "Sticky Inflation: Monetary Policy when Debt Drags Inflation Expectations," co-written with Nicolas Caramp and Dejanir Silva. In fact, our calculations lead to a paradoxical result: the more hawkish the central bank—the more it detests inflation—the less it should raise rates in response to a fiscal shock. The practical guide is equally important. The Fed should lower rates and accept higher inflation today, and it should do so by communicating a modified Taylor rule, clearly announced: raise the inflation target as long as deficits remain unsustainable, and bring it back down once deficits are corrected. This administration has been pressing for lower rates. Give it to them.