The Federal Reserve’s Christopher Waller was recently quoted as saying, ‘the best way to maintain my independence is to not criticise my masters… When I start telling you what to do with fiscal policy, you have every right to start telling me what to do with monetary policy’.
Waller is rightly a highly praised Fed governor and policy-maker. His insights on US labour market dynamics and the prospects for a soft landing defied those of leading US economists and have proven right. OMFIF had the great pleasure of hosting him in a highly informative virtual session several years ago.
But should the Fed be quiet about fiscal policy? Yes and no.
Fed independence
The Fed is viewed as a guardian of the US economy. Its ‘independence’, which Waller correctly puts a high premium on, should be zealously protected and revered.
But there is a difference between telling the government how it should run fiscal policy – though it decidedly needs some sensible advice given how bad a job is being done – and discussing how fiscal policy impacts monetary policy and what that means for the US economy.
Fiscal and monetary policies interact in manifold ways, with clear ramifications for attainment of the ‘dual mandate’. They cannot be divorced from one another.
Congressional Budget Office projections show that debt held by the public will soar from around 100% of gross domestic product currently to 125% under optimistic conditions a decade from now. After that, due largely to entitlement spending as well as a surging interest bill, the deficit soars over following decades towards 170%.
While a rising debt-to-GDP ratio of 125% seems eminently financeable given the attractiveness of US capital markets and the dollar’s global reserve currency/financing role, it corresponds to annual deficits of a whopping 6% of GDP and is horrid policy.
That will heavily impact the environment for Fed decision-making.
Tackling volatility
Deficits of that magnitude will translate into enormous new Treasury issuance, especially bills. That may create greater rollover pressures and heighten prospects for bouts of market indigestion, volatility and financial instability. Much work suggests that US Treasury market liquidity is not as robust as in the past, especially given the increased role that price-sensitive non-banks, able to quickly shift positions, are playing in US capital markets.
Given the centrality of US markets to global finance, US financial turbulence will quickly reverberate worldwide. The Fed has tools to tackle such bouts of volatility, including its new Standing Repo Facility and overnight reverse repo facilities. But frequent episodic instability is hardly desirable.
Such large-scale issuance will push up longer term rates and the term premium, reducing US growth and investment and complicating the Fed’s ability to steer monetary policy. Surveys already point to a rising term premium.
Surging deficits will impact the dollar. In the early 1980s under Ronald Reagan’s presidency, taxes were cut and defence spending hiked when the Fed was sharply tightening monetary policy to wring inflation out of the economy. Fiscal pressures gave interest rates an extra push. The economy plunged into recession and the Midwest’s ‘rust belt’ woes amid this lethal policy mix. The dollar predictably soared, creating major protectionist pressures, which G5 finance ministers and central bank governors, led by US Treasury Secretary James Baker in 1985, pushed back on through the Plaza Accord.
Political pressures
The US’ errant fiscal policy may also ultimately have deleterious impacts for the Fed’s own ‘independence’. To offset the impact of higher rate pressures on the economy, let alone the government’s interest bill, the Fed may come under political pressure to keep a lid on interest rates regardless of inflationary dynamics.
Though the administrations of Bill Clinton, George W. Bush, Barack Obama and Joe Biden adopted a hands-off approach to commenting on monetary policy, deferring to Fed independence – a path Vice President Kamala Harris has pledged to follow – the Donald Trump administration and candidate Trump have not. The politicisation of monetary policy harkens back to the inflationary post-second world war period, which ultimately led to the early 1951 Treasury-Fed accord, freeing the Fed from having to buy Treasuries and allowing it to pursue anti-inflationary policy. Compromising Fed independence would harm US economic policy.
A review of Fed speeches and Federal Open Market Committee minutes is replete with references to energy, oil markets, geopolitical tensions, weather, immigration, strikes, inequality and their implications for the labour market, inflation outlook and thus monetary policy settings.
Fiscal policy is no different. If for no other reason than the Fed’s self-interest in preserving its independence – a public good for the US and the world – the Fed should speak out on what the errant course of US fiscal policy means for the US monetary policy outlook.
The Fed will soon undertake its monetary policy framework review. Fed communications should be one topic on the docket. The review should encourage Fed speakers to educate the public about the meaning of the US fiscal policy course for monetary policy.
Mark Sobel is US Chair of OMFIF.
Image credit: Daniel Foster
