Opinion: Powell Takes the Tax Bus

Chairman of the Federal Reserve Board Jerome Powell


MANDEL NGAN / AFP via Getty Images

Jerome Powell publicly lobbied for months for higher fiscal spending in the name of stimulating the economy. Congratulations to the chairman of the Federal Reserve, who managed to get on the fiscal bus. Now his wish is the command of Treasury Secretary Janet Yellen, as the Fed has to finance the huge fiscal deficits that lie ahead.

That’s the context to consider when the Federal Open Market Committee meets this week amid rising interest rates and market inflation jitters. Fed officials have told the public that there is nothing to worry about, that they have the tools to handle any inflation rate or breakout. But investors aren’t crazy to be vigilant, no matter how gleefully the Fed assures.

The sheer magnitude of the deficits to be financed is a rare experiment in America’s fiscal history. Even before the $ 1.9 trillion spending bill was passed, the Congressional Budget Office estimated the deficit as a percentage of GDP to be 10.3% in fiscal 2021. With the explosion of Pelosi-Schumer-Biden, this fiscal year’s deficit will now be in the neighborhood of 18% of GDP. That is by far the highest since the four war years of 1942-1945.

That’s also a lot of bills, notes, and Treasuries to sell. Historically, US investors have been able to finance between 4% and 5% of GDP. The appetite of foreign buyers will depend on relative interest rates, currency values, and confidence in the US economy. The February 25 Treasury auction of seven-year notes was a warning sign, as low demand nearly 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 US debt for years to come. Currently, the Fed is buying $ 120 billion a month in Treasuries and mortgage securities and (unlike in Europe) there is no limit to the amount it can buy.

The lucky news is that the economy is poised to advance rapidly as the pandemic and social distancing diminish. This year could see the fastest GDP growth since 7.2% in 1984, and the economy is set to regain all the ground it lost during the pandemic as early as this quarter. The main effect of the $ 1.9 trillion will be to steal future growth by giving consumers more money to spend now. The Fed will undoubtedly enjoy this happiness in the short term.

But eventually there is a price for everything in economics, 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 will want to keep them low to finance continuing federal deficits. Political pressure from the Treasury and Biden’s Congress will be enormous to keep rates low as far as the eye can see.

One challenge will be keeping a calm Treasury market. This probably means forgoing again the supplemental 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 banks for holding Treasuries as reserves. This is one of the ways that 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 this on Fed independence. Even asking this question is heresy at the Fed. But because the Fed must continue to buy Treasury debt to finance huge deficits, its ability to reduce the purchase of bonuses is limited. Ms. Yellen is a former Fed chairman and Nellie Liang, who was considered to be an undersecretary of the Treasury for national finances, was one of the Fed’s top employees. Biden’s Treasury and Powell’s Fed are united in the politics hip.


This won’t matter in the short term as the economy ramps up, but the problem will come if inflation or interest rates rise beyond the Fed’s comfort zone. The Fed will then face conflicting pressures from the markets, for one side, and the Treasury, on the other.

That’s what happened in 1951, when prices went up in the middle of the Korean War. The result was what became known as the Agreement between the Treasury and the Fed that separated the management of public debt from monetary policy, giving rise to the modern era of Fed independence. It is no exaggeration to say that financial panic 2008 and the pandemic have returned the Fed to a pre-Accord role.

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

Magazine Editorial Report: Biden and the Democrats Are Crushing Him From the Left. Image: Alex Brandon / Associated Press

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It appeared in the print edition of March 16, 2021.


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