Yesterday, I sent you a short quip on application of the reality principle to economics and finance, what seems to me to be an ethical position of great integrity. Today, the Editorial Board of the Wall Street Journal added its own thinking about who will actually pay for “lunch” here in the U.S. I include excerpts from the editorial here:
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.
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.