Notice: Powell catches the tax bus

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

It is also a lot of treasury bills, notes and bonds to sell. US investors have historically managed to finance 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 sign, as reduced demand almost failed.

Since then, treasury auctions have been more robust, but there is no doubt that the Fed will be a massive buyer of US debt for years to come. The Fed currently buys $ 120 billion a month in treasury and mortgages, and (unlike Europe) there is no limit to the amount it can buy.

The lucky news is that the economy is about to move forward as the pandemic and social distancing ease. This year could see the fastest GDP growth of 7.2% in 1984, and the economy is poised to cover all the ground it lost during the pandemic immediately after this quarter. The main effect of the $ 1.9 trillion will be to rob future growth, giving consumers more money to spend now. The Fed will no doubt rely on this short-term happiness.

But in the end, 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 ask for higher interest rates, even if the Fed will want to keep them low to fund ongoing federal deficits. Political pressure from the Biden Treasury and Congress will be enormous to keep rates as low as it can see.

A challenge will be to maintain a calm Treasury market. This probably means giving up the additional leverage rate for banks again, a measure of capital adequacy. The Fed dropped the rule last April, and the waiver expires on March 31. Restoring it would penalize banks for holding treasuries as reserves. This is one way in which the government’s response to the pandemic will continue to block a return to normal monetary and regulatory policy.

Another issue is the effect of all this on Fed independence. Even raising this question is heresy at the Fed. But because the Fed still needs 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, considered a treasurer under the Secretary of the Interior, was a top Fed staffer. Biden Treasury and Fed Powell are joined at the policy level.

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This will not count 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 was the case in 1951, as prices rose amid the Korean War. The result was what became known as the Treasury-Fed Agreement, which separated public debt management from monetary policy, giving rise to 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-agreement 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.