Opinion: Powell takes the tax bus

The magnitude of the deficits to be financed is a rare experience in the fiscal history of the United States. Even before the $ 1.9 trillion spending bill was passed, the Congressional Budget Office estimated that the deficit as a share of GDP would be 10.3% in fiscal year 2021. With the explosion of Pelosi -Schumer-Biden, the deficit this fiscal year will now be close to 18% of GDP. It is by far the largest since the four years of war of 1942-1945.

This is also a lot of Treasury bills, notes and bonds to sell. American investors have historically been able to finance about 4% to 5% of GDP. The appetite of foreign buyers will depend on relative interest rates, monetary values ​​and confidence in the US economy. The February 25 Treasury auction of seven-year notes was a warning sign, as low demand almost led to failure.

Treasury auctions have since been more robust, but there is little doubt that the Fed will be the major buyer of US debt in the years to come. The Fed is currently buying $ 120 billion a month in Treasury bills 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 about to grow as the pandemic and social detachment diminish. This year it may have the fastest GDP growth since 7.2% in 1984, and the economy is ready to recover all the ground it lost during the pandemic this quarter. The main effect of the $ 1.9 trillion will be to steal the growth of the future, giving consumers more money to spend now. The Fed will undoubtedly delight in this short-term happiness.

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

One of the challenges will be to maintain a calm Treasury market. This probably means renouncing the Supplemental Leverage Index for banks again, a measure of capital adequacy. The Fed waived the rule last April and the waiver expires on March 31. Restoring it now would penalize banks for holding Treasury bills as reserves. This is one way 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 of this on the Fed’s independence. Even raising this issue is a heresy of the Fed. But, since the Fed needs to continue buying Treasury bills to finance huge deficits, its ability to reduce bond buying is limited. Ms. Yellen is a former Fed chairman and Nellie Liang, considered the undersecretary of the Treasury for domestic finance, was an important career employee of the Fed. The Biden Treasury and the Powell Fed are united on the policy hip.

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It doesn’t matter in the short run as the economy grows, but the problem will come if inflation or interest rates rise beyond the Fed’s comfort zone. So the Fed will face conflicting market pressures on the one hand, and Treasury, on the other.

It happened in 1951, when prices rose in the middle of the Korean War. The result was what became known as the Treasury-Fed Agreement, which separated government debt management from monetary policy, giving rise to the modern era of the Fed’s independence. the pandemic pushed the Fed back to its pre-Accord role.

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