Posted:September 16, 2025
Categories: Federal Reserve, Central Bank, Credit, Economy, Fiat Currency, Inflation, Interest Rates, Monetary Policy
In the opening scene of the film Gladiator, the main character, Maximus (played by Russell Crowe), leads the Roman army in a decisive victory against the Germanic tribes. It was the year 180 AD, which, historically, marked the apex of Rome’s power. On the night of that victory, there is a pivotal scene where the frail and dying Marcus Aurelius (Caesar) is about to ask Maximus to succeed him on the throne instead of his son and heir, Commodus. He recognizes that Commodus is not a moral or virtuous man and thus not a suitable heir to rule Rome. Instead, Marcus Aurelius wants Maximus to assume power, therefore realizing the dream of a Roman Republic, as power would pass to the Senate instead of absolute rule by the next Caesar to take the throne.
Marcus Aurelius knows that what he is about to ask is tantamount to treason against his own bloodline. He also knows that Commodus would not accept the news well. To soften the blow, he has a heartfelt exchange with his daughter, Lucilla, where he asks for her help in consoling Commodus. In a moment of regret for the father he has failed to be, he presents a hypothetical scenario to persuade her to help, in which he says,
"Let us pretend that you are a loving daughter and I am a good father."1
Lucilla smiles and responds,
"This is a pleasant fiction, isn't it?"
Battle for the Fed
A battle is currently brewing between the Federal Reserve Board, responsible for the nation's monetary policy, and the fiscal authorities, responsible for the nation’s fiscal policy. The Federal Reserve manages monetary policy, which involves setting short-term interest rates and controlling the supply of money in the system. Fiscal policy consists of the government's decisions regarding taxation and spending to influence economic activity, manage aggregate demand, fight recessions, or curb inflation. The current battle is not new, as many politicians have battled Federal Reserve governors since the 1950s. Both players are supposed to act independently of one another, dating back to the Treasury-Fed Accord of 1951.
Game Theory & Fed Policy
Let us pretend now that the Federal Reserve and politicians are independent. Alan Blinder, a Princeton professor and former member of the Federal Reserve Board, published a paper in 1982, where he presented a "simple game-theoretic argument" to explain observed policy mixes. 2 I have replicated this matrix below in Figure 1.
Figure 1. Monetary-Fiscal Payoff Matrix
Source: Alan Blinder 3
There are two players in this game: the politicians and the Fed. 4
The politicians (e.g., Congress and the White House) are assumed to favor expansionary policies, with their best outcome being when both authorities pursue expansion (rank 1 in the lower right-hand corner), and their worst outcome when both contract (rank 4 in the upper left-hand corner). This makes sense, as politicians have short terms and are always looking to get reelected. Their preferred outcome “juices” the economy, which, all in all, is favorable for reelection campaigns.
The monetary authority (e.g., the Federal Reserve) is assumed to be "fighting inflation" and thus favors contractionary policies, ranking outcomes opposite to the fiscal authority. This also makes sense as Fed governors and board members have much longer terms and a dual mandate to control inflation and ensure full employment. “Juicing” the economy risks stoking inflation.
In our fictional scenario, where we are imagining these players as being independent, the “Nash Equilibrium” occurs in the lower left-hand corner of the matrix (rank 3 for each player), when the Fed plays contraction (e.g., higher interest rates). The fiscal authority plays an expansionary role (e.g., budget deficits and lower taxes). The model demonstrates that even if both parties might prefer an alternative mix (like fiscal contraction and monetary expansion), they become "trapped into the opposite policy mix by the inability to coordinate."
A Pleasant Fiction Indeed
The reality facing today’s politicians is a never-ending budget deficit with the inability to lower spending and increase taxes. We are living in a world of fiscal dominance where the actions of the fiscal authorities are overwhelming the actions of the Fed. With a large budget deficit and the need to sell more debt, the fiscal authorities need lower interest rates.
Stuck between a rock and a hard place, a hesitant Fed is now widely expected to lower short-term interest rates by 0.25% on Wednesday. Furthermore, the market is pricing in two additional 0.25% interest rate cuts by the end of 2025.
We are headed for expansionary policies from both players, which, all in all, will likely stoke inflation and benefit asset prices. It’s also looking more and more likely that both the Fed and the Treasury will be coordinating actions moving forward. For now, pretending the Fed is independent is a pleasant fiction indeed.
To be continued in…“A Pleasant Fiction: Part II”
References
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