Opinion: Powell catches the tax bus

The size of the deficits to be financed is a rare experience in the fiscal history of the United States. Even before the passage of the $ 1.9 trillion spending bill, the Congressional Budget Office estimated that the deficit as a percentage of GDP would be 10.3% in fiscal year 2021. With the burst of Pelosi-Schumer-Biden, the deficit for this year will now be close to 18% of GDP. This is by far the highest since the four years of war from 1942 to 1945.

It’s also a lot of treasury bills, notes and bonds for sale. American investors have historically been able to finance around 4-5% of GDP. The appetite of foreign buyers will depend on relative interest rates, the value of currencies, and confidence in the US economy. The Feb. 25 auction of seven-year Treasury bills was a warning sign, as weak demand almost led to failure.

Since then Treasury auctions have been more robust, but there is no doubt that the Fed will be a big buyer of US debt for years to come. The Fed currently buys $ 120 billion a month in treasury bills and mortgage securities, and (unlike Europe) there is no limit on how much it can buy.

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

But ultimately, there is a price for everything in economics, notwithstanding the assurances of modern monetary theory. The test for the Fed will come in the coming months with the economic recovery. The market may demand higher interest rates, even as the Fed will want to keep them low to finance persistent federal deficits. Political pressure from Biden Treasury and Congress will be enormous to keep rates low as far as the eye can see.

One challenge will be to maintain a calm treasury market. This probably means again giving up the additional leverage ratio for banks, a measure of capital adequacy. The Fed waived the rule last April and the waiver expires on March 31. Restoring it now would penalize the banks for holding treasury bills as reserves. This is one way the government’s response to the pandemic will continue to block a return to normal monetary and regulatory policy.

Another problem is the effect of all of this on the independence of the Fed. Even raising this issue is heresy at the Fed. But because the Fed must continue to buy Treasury debt to fund huge deficits, its ability to reduce its bond purchases is limited. Ms Yellen is a former Fed chairman, and Nellie Liang, supposedly Under Secretary of the Treasury for Home Finances, was one of the Fed’s best careers. Both Treasury Biden and Fed Powell are associated with the political hip.

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It won’t matter in the near term with the economy booming, but the catch will come if inflation or interest rates rise beyond the Fed’s comfort zone. Then, the Fed will have to face conflicting pressures from the markets on the one hand and from the Treasury on the other.

This is what happened in 1951, as prices went up during the Korean War. The result was what has come to be called the agreement between the Treasury and the Fed that separated public debt management from monetary policy, giving rise to the modern era of Fed independence. It is no exaggeration to say that the 2008 financial panic and pandemic returned the Fed to 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 political consequences. Mr. Powell won’t be able to say he warned us.