Opinion: Powell Catches the Fiscal Bus


Federal Reserve Board Chairman Jerome Powell



Photo:

MANDEL NGAN/AFP via Getty Images

Jerome Powell

lobbied publicly for months for more fiscal spending in the name of spurring the economy. Congratulations to the Federal Reserve Chairman, who has succeeded in catching the fiscal bus. Now his wish is Treasury Secretary

Janet Yellen’s

command as the Fed has to finance the vast fiscal deficits to come.

That’s the context to consider as the Federal Open Market Committee meets this week amid rising interest rates and market inflation jitters. Fed officials have been telling the public there is nothing to worry about, that they have the tools to manage any rate or inflation breakout. But investors aren’t crazy to be watchful, no matter how blithely the Fed assures.

The sheer magnitude of the deficits to be financed is a rare experiment in U.S. fiscal history. Even before the $1.9 trillion spending bill passed, the Congressional Budget Office estimated the deficit as a share of GDP would be 10.3% in fiscal 2021. With the Pelosi-Schumer-Biden blowout, the deficit this fiscal year will now be in the neighborhood of 18% of GDP. That’s the highest by far since the four wartime years of 1942-1945.

That’s also a lot of Treasury bills, notes and bonds to sell. U.S. investors have historically been able to finance about 4%-5% of GDP. The appetite of foreign buyers will depend on relative interest rates, currency values and confidence in the U.S. economy. Treasury’s Feb. 25 auction of seven-year notes was a warning sign as low demand almost led to failure.

Treasury auctions since have been more robust, but there’s little doubt that the Fed will be a bulk purchaser of U.S. debt for years to come. The Fed is currently buying $120 billion a month of Treasurys and mortgage securities, and (unlike in Europe) there is no limit on the amount it can buy.

The fortunate news is that the economy is about to zoom ahead as the pandemic and social distancing ease. This year could see the fastest GDP growth since 7.2% in 1984, and the economy is poised to make up all of the ground it lost during the pandemic as soon as this quarter. The main effect of the $1.9 trillion will be to rob growth from the future by giving consumers more money to spend now. The Fed will no doubt bask in this near-term happiness.

But eventually there is a price for everything in economics, notwithstanding the assurances of modern-monetary theory. The test for the Fed will come in future months as the economy recovers. The market may demand higher interest rates, even as the Fed will want to keep them low to finance continuing federal deficits. The political pressure from the Biden Treasury and Congress will be enormous to keep rates low as far as the eye can see.

One challenge will be maintaining a calm Treasury market. This probably means waiving again the Supplementary Leverage Ratio for banks, a measure of capital adequacy. The Fed waived the rule last April and the waiver expires March 31. Restoring it now would penalize banks for holding Treasurys as reserves. This is one way in which the government response to the pandemic will continue to block a return to normal monetary and regulatory policy.

Another issue is the effect of all this on Fed independence. Even to raise this question is heresy at the Fed. But because the Fed must keep buying Treasury debt to finance huge deficits, its ability to taper bond buying is limited. Ms. Yellen is a former Fed Chair and

Nellie Liang,

pegged to be Treasury under secretary for domestic finance, was a top career staffer at the Fed. The Biden Treasury and Powell Fed are joined at the policy hip.

***

This won’t matter in the short-term as the economy booms, but the rub will come if inflation or interest rates rise beyond the Fed’s comfort zone. Then the Fed will face conflicting pressure from markets on the one hand and Treasury on the other.

That’s what happened in 1951, as prices rose amid the Korean War. The result was what became known as the Accord between Treasury and the Fed that separated government debt management from monetary policy, giving birth to the modern era of Fed independence. It’s not too much to say that the financial panic of 2008 and the pandemic have pushed the Fed back into a pre-Accord role.

Good luck to Chairman Powell and the FOMC in this brave new world in which politicians believe they can spend as much as they want without policy consequences. Mr. Powell won’t be able to 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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Appeared in the March 16, 2021, print edition.



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