Opinion: Powell takes the tax bus

The large magnitude of the deficits to be financed is a rare experiment in the fiscal history of the United States. Even before the $ 1.9 trillion spending bill was passed, the Congressional Budget Office estimated the deficit as a share of GDP would be 10.3% during the fiscal year. 2021. With the Pelosi-Schumer-Biden outbreak, the deficit of this 18% of GDP. This is the highest by far since the four years of war of 1942-1945.

This also means selling a lot of Treasury bonds, banknotes and bonds. Historically, American investors have 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. The February 25 seven-year Treasury note auction was a warning sign, as low demand almost led to failure.

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

Lucky luck is that the economy is about to move forward as the pandemic and social distancing ease. This year could experience the fastest GDP growth since 7.2% in 1984, and the economy is about to make up all the ground it lost during the pandemic as soon as this quarter. The main effect of the $ 1.9 trillion will be to steal the growth of the future by giving consumers more money to spend now. No doubt the Fed will take that happiness in the short term.

But in the end, there is a price for everything in economics, despite the guarantees of modern monetary theory. The Fed’s test will come in the coming months as the economy recovers. The market may demand higher interest rates, although the Fed will want to keep them low to fund ongoing federal deficits. The political pressure from the Treasury and Biden Congress will be enormous to keep rates low as far as can be seen.

One challenge will be to keep a Treasury market quiet. This will probably mean giving up the supplementary leverage ratio for banks again, a measure of capital adequacy. The Fed dropped the rule last April and the waiver expires on March 31. Restoring it now would penalize banks for having treasures as reserves. This is one of the ways in which the government’s response to the pandemic will continue to block the return to normal monetary and regulatory policy.

Another issue is the effect of all this on the independence of the Fed. Even raising this issue is a Fed heresy. But because the Fed must continue to buy Treasury debt to finance huge deficits, its ability to reduce bond purchases is limited. Ms. Yellen is a former Fed chairman and Nellie Liang, linked to being secretary of the Treasury for national finances, was one of the top Fed officials. The Biden Treasury and the Fed Powell join the political chain.

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This won’t matter in the short term as the economy grows, but the frequency 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 the Treasury on the other.

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

Good luck to President Powell and the FOMC in this brave new world where politicians believe they can spend whatever they want without political consequences. Mr. Powell will not be able to say that he warned us.