Debt's Diminishing Returns: Why Cheap Credit Fails to Fuel Sustainable Growth

The conventional wisdom that cheap credit is the primary fuel for economic growth is facing a stark empirical challenge. The data reveals a growing disconnect: while the government is spending a record amount to service its debt, the private sector is actually deleveraging. This sets up a fundamental tension at the heart of today's monetary policy debate.

The fiscal burden is immense. The federal government spent $970 billion on interest payments in fiscal year 2025, an amount that represents 3.2% of GDP and 14% of all federal outlays. This is the direct cost of a large and growing debt, and it is rising as market rates climb. The pressure is political, with calls for the Federal Reserve to cut rates to lower these costs. Yet, the private sector is not responding with a surge in borrowing to drive expansion. Instead, the total private nonfinancial-sector debt-to-GDP ratio has reached its lowest level in two decades.

This is the core disconnect. The primary driver of current monetary policy debates is not a broad private sector demand for cheap credit to fund investment or consumption. It is fiscal stress. The government's need to reduce its borrowing costs is creating a powerful political push for lower interest rates. But the private sector's balance sheets tell a different story. Both business and household debt levels are declining relative to the size of the economy. For businesses, while leverage remains elevated in some areas, interest coverage ratios improved slightly and remained at moderate levels. Households, buoyed by high equity in homes and older, low-rate mortgages, are also paying down debt. The vulnerabilities that remain are concentrated in riskier segments, not the economy as a whole.

The implication is clear. Sustained cheap credit expansion is not a reliable engine for broad-based growth because the private sector is not seeking it. The engine is already running on a different fuel: fiscal policy. When the Federal Reserve is pressured to cut rates to serve the Treasury's balance sheet, it risks stepping off its mandate of price stability and maximum employment. History shows that when central banks are forced to finance deficits, the likely result is inflation, not sustainable growth. The current setup is less about stimulating demand and more about managing a fiscal imbalance that the private sector is, for now, not helping to solve.

Structural Risks: How Cheap Credit Distorts the Economy

The current setup creates a dangerous feedback loop. The Federal Reserve is effectively constrained from performing its core function of managing inflation because doing so would directly increase the cost of servicing the largest debt in history. The political pressure to cut rates to save the Treasury money is not a mere policy preference; it is a structural risk to the central bank's independence. As former Fed Chair Janet Yellen has warned, fiscal dominance is dangerous because it typically results in higher and more volatile inflation. When the central bank is pressured to keep rates low to reduce debt service, it risks unanchoring long-term inflation expectations. Households and firms may come to expect that inflation is the path of least resistance, which can become self-fulfilling.

This environment also distorts capital allocation in subtle but powerful ways. When borrowing is cheap and abundant, it can flow to the most politically connected or financially engineered projects, not necessarily those with the highest economic return. The result is a misallocation of resources that inflates asset prices, particularly in real estate and equities, without a corresponding boost to productive capacity or broad-based wage growth. These vulnerabilities are not captured in headline GDP figures, which can still show expansion while the underlying economy becomes more fragile and unequal. The risk is a growth model that is increasingly dependent on asset bubbles rather than durable productivity gains.

Historically, this dynamic has been a recipe for instability. The most direct precedent is the Treasury-Fed Accord of 1951. That agreement was forged after President Truman's attempt to force the Fed to keep long-term rates low during the Korean War. The Fed's refusal to be a mere fiscal agent led to the Accord, which formally established its independence. The lesson is clear: when monetary policy is subordinated to fiscal needs, the result is often inflation, not sustainable growth. Today, the pressure is not from a war but from a peacetime debt burden that is rising faster than the economy. The Fed's current stance is a guardrail against a repeat of that history, but the political winds are shifting. The danger now is that sustained low rates driven by fiscal need could gradually erode the credibility of the central bank's commitment to price stability, setting the stage for a more damaging bout of inflation down the road.

Historical Precedents and Forward-Looking Scenarios

The lessons of history are stark. The Treasury-Fed Accord of 1951 was a direct response to a president's attempt to force the central bank to keep rates low to finance a war. When the Fed refused, it preserved its independence and averted a path of sustained inflation. Today, the pressure is not from a conflict but from a peacetime debt burden that is rising faster than the economy. The political winds are shifting, with President Trump repeatedly calling for the Fed to cut rates to lower the cost of financing the debt, even suggesting a target of 1% or lower. This is a clear signal of a potential shift in the policy framework, moving toward what economists call "fiscal dominance".

The trajectory of the federal debt-to-GDP ratio will be the key variable that intensifies this pressure. The ratio has been on a steady climb, and even a modest acceleration would dramatically increase the political cost of higher rates. As the Congressional Budget Office notes, a mere 0.1 percentage point increase in interest rates each year would add hundreds of billions to future deficits. This creates a powerful incentive for policymakers to prioritize reducing Treasury borrowing costs over the Fed's dual mandate. The market's forward view must therefore track this ratio not just as a fiscal metric, but as a direct input into the political calculus for monetary policy.

The ultimate test will be inflation. If core inflation and wage growth remain sticky, it would directly challenge the political will to maintain low rates for fiscal reasons. The Fed's credibility hinges on its ability to anchor expectations. Sustained low rates driven by fiscal need, rather than economic conditions, risk unmooring those expectations. As former Fed Chair Janet Yellen has warned, fiscal dominance typically results in higher and more volatile inflation. The forward-looking scenario is one where the Fed is caught between a rock and a hard place: raise rates to fight inflation and face a political storm over Treasury costs, or keep rates low to appease fiscal demands and risk a longer bout of inflation that could be more damaging.

The risk is a repeat of the historical precedent, but in a more subtle form. The Fed may not formally capitulate to a president's demand for 1% rates, but it could gradually ease policy in ways that are effectively accommodating fiscal pressures. This would be a slow erosion of independence, with the central bank's primary tool being used to serve the Treasury's balance sheet. The market's job is to watch for any formal or informal communication from the Fed that signals a shift in its policy framework. The setup is less about a sudden policy change and more about a gradual drift toward a model where cheap credit is a fiscal tool, not an engine for sustainable growth.