What Can the Fed Do About the Deficit? Nothing | Mint

What Can the Fed Do About the Deficit? Nothing

The bond selloff is giving the Fed an added reason not to raise interest rates. PHOTO: SARAH SILBIGER/REUTERS
The bond selloff is giving the Fed an added reason not to raise interest rates. PHOTO: SARAH SILBIGER/REUTERS

Summary

As deficits fuel rising bond yields, Fed Chair Jerome Powell has resisted the urge to offer fiscal advice, in contrast to 2020.

Federal Reserve officials say soaring long-term bond yields are a key factor in the economic outlook and their interest-rate decisions. They also say the swelling federal deficit is one reason yields are rising.

What they won’t say is that political leaders should therefore do something about the deficit.

“We don’t comment on fiscal policy," Fed Chair Jerome Powell told a questioner after a speech last week. “We know that we’re on an unsustainable path fiscally."

Powell’s reticence is understandable. But it is also selective. In 2020, when pandemic lockdowns tipped the economy into a sharp, severe contraction, Powell had a lot to say about fiscal policy.

A contrast to 2020

After Congress passed and President Donald Trump signed the $2.2 trillion Cares Act, Powell repeatedly called for more stimulus. “This is the time to use the great fiscal power of the United States to do what we can to support the economy," he said in April 2020.

Powell kept up his support through fall 2020. And while he didn’t explicitly back President Biden’s $1.9 trillion American Rescue Plan in early 2021, he did play down concern that inflation could result.

His call for more fiscal support was, at the time, well-founded. The early-2020 lockdowns represented an unprecedented calamity. The Fed had already cut short-term interest rates to near zero and was buying bonds to push down long-term rates; fiscal policy was the only lever left to support the economy.

Nonetheless, Powell’s outspoken support for fiscal stimulus then is awkward now, for two reasons. First, given how strong both the recovery and inflation turned out to be, much of the extra stimulus was unneeded and maybe counterproductive.

Second, it stands in contrast to his silence today—a silence some wish he would break. In 2020, Powell “felt that, for the needs of the nation, he had to weigh in on fiscal policy," Paul Ryan, former Republican speaker of the House of Representatives, told me. “I feel that need has arisen again but on the other side of the ledger, on debt and on spending."

Biden and Trump, likely the major parties’ presidential contestants in next year’s election, “are promising not to do anything about our debt," Ryan said. “That’s five more years of this. The Fed chair can’t sit by and say nothing."

Deficit threat isn’t distant or hypothetical

To be sure, the deficit is far from the disaster the pandemic was in 2020. But nor is it some distant, hypothetical threat. The gap in the fiscal year ended Sept. 30, adjusted for student loan-related accounting, hit $2 trillion, or 7.5% of gross domestic product, a record outside war, recession or national emergency, and there is no prospect of its coming down meaningfully. The resulting supply of Treasury securities caught investors by surprise.

Rising bond yields, though only partially due to deficits, have also had destabilizing spillovers in markets. They have reduced the value of banks’ bondholdings, eroding banks’ solvency. Because Treasurys are the world’s de facto benchmark security, their higher yields have pushed up rates in other countries, too.

And while the Fed can’t argue that a lower deficit is necessary to stave off an imminent crisis, it can certainly point out that it would make it easier to get inflation back down to its 2% target.

And yet for all the reasons Powell might want lawmakers to act on the deficit, he also has reasons to keep quiet. For starters, the implications for monetary policy are a bit counterintuitive.

Normally, a bigger deficit stimulates growth and causes the Fed to tighten monetary policy. But the latest run-up in yields doesn’t reflect higher expected growth, but a higher term premium—the added return investors demand to hold long-term bonds instead of shorter-term Treasury bills.

That higher term premium is a restraint on borrowing and spending now. As Richard Clarida, a former vice chair, put it, “Your past fiscal excesses show up as a headwind today." In other words, the bond selloff is giving the Fed an added reason not to raise interest rates, not exactly an incentive for Washington to quit borrowing.

Meddle with Congress, Congress meddles back

Then, there is the risk that if Powell has skin in the fiscal game, critics read ulterior motives into his actions. In 1990, the Fed, under Chairman Alan Greenspan, cut rates after President George H.W. Bush and Congress reached a deficit deal. Since then, the Fed has generally avoided so explicit a link between monetary and fiscal policy.

Which hasn’t prevented suspicions of one. A decade ago, under Chair Ben Bernanke, the Fed bought bonds (dubbed quantitative easing) to support growth and nudge up too-low inflation. Republicans, including Ryan, accused him of “bailing out" President Barack Obama’s deficits. The Fed is now getting rid of those bonds as part of its campaign to get inflation down (quantitative tightening). Would Democrats accuse Powell of doing so to punish congressional profligacy?

Finally, the Fed should put its reputation on the line only if it has any chance of accomplishing something. In the early 1990s, Congress was less polarized and presidents were more willing to make hard choices on debt. Today, the parties are so polarized that they only listen to views they already agree with. Both oppose cutting Social Security or Medicare, the two biggest spending programs, or raising taxes on most Americans.

For now, Powell’s advice would make little difference—and possibly enemies.

Write to Greg Ip at greg.ip@wsj.com

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