Advice: Powell catches the fiscal bus

The huge deficit that needs to be funded is a rare experiment in U.S. fiscal history. Congress’s budget office estimated that the deficit as a share of GDP would be 10.3% in fiscal 2021, even before the $ 1.9 billion spending bill was passed. With the blowout of Pelosi-Schumer-Biden, the deficit this year will now be in the region of 18% of GDP. This is by far the highest since the four war years of 1942-1945.

There are also many treasury bills, letters and bonds to sell. US 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 US economy. The Treasury’s auction of seven years on seven years was a warning sign on February 25 because the low demand almost led to failure.

Treasury auctions have been more robust since then, but there is little doubt that the Fed will be a bulk buyer of US debt for years to come. The Fed currently buys $ 120 billion a month in Treasury and mortgage bonds, and (unlike in Europe) there is no limit to the amount it can buy.

The good news is that the economy is on the verge of zooming forward as the pandemic and social distance ease. This year could yield the fastest GDP growth since 7.2% in 1984, and the economy is ready to compensate for all the land it lost during the pandemic. The main effect of the $ 1.9 billion will be to rob growth of the future by giving consumers more money to spend now. The Fed will no doubt cherish this short-term disaster.

But in the end, there is a price for everything in the economy, regardless of the assurance of modern-monetary theory. The test for the Fed will take place in the coming months as the economy recovers. The market may demand higher interest rates, even if the Fed wants to keep it low to finance continued 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 is to maintain a calm treasury market. This probably means that the supplementary leverage ratio for banks will have to give up again, a measure of capital adequacy. The Fed waived the rule last April and the waiver expires on March 31. If the bank is restored now, it will punish banks for keeping Treasurys as reserves. This is one way in which the government’s response to the pandemic will continue to reverse the return to normal monetary and regulatory policy.

Another problem is the impact of all this on the independence of the Fed. Even raising this question is heresy at the Fed. But because the Fed continues to buy treasury debt to finance large deficits, its ability to buy bonds is limited. Me. Yellen is a former chairman of the Fed and Nellie Liang, who was appointed treasurer under the Secretary of the Interior, was an excellent career staffer at the Fed. The Biden Treasury and Powell Fed are joining the policy firm.

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It will not matter in the short term because the economy is booming, but inflation will come if inflation or interest rates rise outside the Fed’s comfort zone. Then the Fed will experience conflicting pressure from the markets on the one hand and the Treasury on the other.

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

Good luck to President 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 will not be able to say that he warned us.