Advice: Powell catches the tax bus

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

That is also a lot of treasury bills, notes and bonds to sell. US investors have historically been able to fund about 4% -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, as low demand nearly led to failure.

Treasury auctions have been more robust since then, 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 instruments, and (unlike in Europe) there is no limit to the amount it can buy.

The happy news is that the economy is on the verge of zooming forward as the pandemic and social distance diminish. This year could see the fastest GDP growth since 7.2% in 1984, and the economy is poised to make up for all of its lost ground during the pandemic as early as this quarter. The main effect of the $ 1.9 trillion will be robbing growth of the future by giving consumers more money to spend now. The Fed will undoubtedly enjoy this happiness in the short term.

Ultimately, however, there is a price for everything in economics, despite the assurances 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 fund persistent 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 of the challenges is to maintain a calm Treasury market. This probably means that we should again forgo the additional leverage ratio for banks, a measure of capital adequacy. The Fed waived the rule in April last year and the exemption expires on March 31. If it is restored now, banks will be penalized for holding treasuries as reserves. This is one way the government’s response to the pandemic will continue to block a return to normal monetary and regulatory policies.

Another problem is the effect of all this on the Fed’s independence. Even asking this question is heresy at the Fed. But because the Fed must continue to buy treasury bills to fund massive deficits, its ability to phase out bond buying is limited. Ms. Yellen is a former Fed chair and Nellie Liang, linked to the post of Treasury Secretary, was a top executive at the Fed. The Biden Treasury and Powell Fed join the policy hip.

This doesn’t matter in the short term as the economy is booming, but the problem will come if inflation or interest rates rise outside the Fed’s comfort zone. Then the Fed will face conflicting pressures from markets on the one hand and Treasury on the other.

That’s what happened in 1951 when prices soared during the Korean War. The result was what became known as the Treasury-Fed agreement that separated government debt management from monetary policy, thus birthing the modern era of Fed independence. It’s not too much to say that the 2008 financial panic and pandemic pushed the Fed back into a pre-Accord role.

Good luck to Chairman Powell and the FOMC in this brave new world where politicians believe they can spend as much as they want with no policy implications. Mr. Powell can’t say he warned us.