Jerome Powell, Chairman of the Federal Reserve Board
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For months, Jerome Powell publicly campaigned for more household spending to stimulate the economy. Congratulations to the chairman of the Federal Reserve who managed to get on the fiscal bus. Now his wish is the command of Treasury Secretary Janet Yellen as the Fed has to finance the huge budget deficits.
This is the context to consider when the Federal Open Market Committee meets this week in the face of rising interest rates and fluctuations in market inflation. Fed officials have told the public there is no need to worry that they have the tools to manage any interest rate or inflation breakout. But investors aren’t crazy to be vigilant, no matter how happily the Fed says.
The extent of the deficits to be funded is a rare experiment in US financial history. Even before the $ 1.9 trillion spending bill was passed, the Congressional Budget Office estimated the deficit as a percentage of GDP at 10.3% for fiscal 2021. With the outbreak of Pelosi-Schumer-Biden, the deficit for this fiscal year will now be near 18% of GDP. This is by far the highest value since the four years of war 1942-1945.
That’s also a lot of Treasury bills, notes, and bonds that need to be sold. US investors have historically been able to finance around 4 to 5% of GDP. Foreign buyers’ appetites will depend on relative interest rates, currency values, and confidence in the US economy. The Treasury Department’s auction of seven-year notes on February 25 was a red flag as low demand almost led to failure.
Treasury bond auctions have been more resilient since then, but there is no doubt that the Fed will be a major buyer of US debt in the years to come. The Fed is currently buying $ 120 billion a month in government bonds and mortgages, and (unlike in Europe) there is no limit to the amount it can buy.
The lucky news is that in the face of the pandemic and social distancing, the economy is about to move forward. This year could see the fastest GDP growth since 7.2% in 1984, and the economy is poised to make up for all the ground it lost during the pandemic as early as this quarter. The main effect of the $ 1.9 trillion will be to rob future growth by giving consumers more money to spend now. The Fed will no doubt look forward to this short-term luck.
But at some point, despite the assurances of modern monetary theory, there is a price for everything in economics. The test for the Fed will take place in the coming months when the economy recovers. The market could charge higher interest rates even if the Fed wants to keep them low to fund the ongoing federal deficits. Political pressure from the Treasury Department and von Biden’s Congress will be enormous to keep interest rates down as low as possible.
Maintaining a quiet treasury market will be a challenge. This probably means that the supplementary leverage ratio for banks will again be dispensed with, a measure of capital adequacy. The Fed waived the rule last April, and the exemption expires on March 31st. Restoration would penalize banks for holding treasuries as reserves. In this way, the government’s response to the pandemic will continue to block the return to normal monetary and regulatory policies.
Another problem is the impact of all of this on the independence of the Fed. Even asking that question is a heresy at the Fed. However, as the Fed continues to need to buy government bonds to fund large deficits, its ability to reduce bond purchases is limited. Ms. Yellen is a former Fed chairperson, and Nellie Liang, who serves as Secretary of the Treasury under the Secretary for Domestic Funding, was one of the best career workers at the Fed. The Biden Treasury and the Powell Fed are united on the political hip.
This won’t matter in the short term as the economy is booming, but the problem will arise when inflation or interest rates rise beyond the Fed’s comfort zone. Then the Fed will face conflicting pressures from the markets on the one hand and the Treasury Department on the other.
It did so in 1951 when prices rose during the Korean War. The result was the so-called Treasury-Fed Agreement that separated government debt management from monetary policy and ushered in the modern era of Fed independence. It is not too much to say that the 2008 financial panic and pandemic put the Fed back into a pre-deal role.
Good luck to Chairman Powell and the FOMC in this brave new world where politicians believe they can spend as much as they want without political ramifications. Mr. Powell can’t say he warned us.
Journal Editorial Report: Biden and the Democrats are crushing it from the left. Image: Alex Brandon / Associated Press
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Published in the print edition on March 16, 2021.