Failure to curb deficit spending and halt the concomitant explosion of the federal debt would present the Federal Reserve with some very unpleasant monetary policy choices in coming years, a former Fed governor and other top economists warn in a report released Friday.
At the very least, as debt grows as a percent of gross domestic product and interest on the debt becomes an ever larger component of the annual budget, political pressure on the Fed will mount to hold down interest rates at the cost of rising inflation expectations, former Fed Gov. Frederic Mishkin and his colleagues caution.
The Fed might well be pressured into delaying its exit from it "highly accommodative" monetary policy stance for fear its annual remittances to the U.S. Treasury would fall or even vanish, further worsening the federal government's fiscal picture, write Mishkin and fellow authors David Greenlaw, James Hamilton and Peter Hooper.
The Fed could suffer large losses on its securities portfolio, possibly exceeding its capital, they say.
In the worst case, the Fed might be forced to "monetize" the debt in a kind of inflationary default, Mishkin and company warn in a thick report presented at a conference sponsored by the University of Chicago Booth School of Business.
One consequence could be "a flight from the dollar."
"Ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy," write Mishkin of Columbia University, Greenlaw of Morgan Stanley, Hamilton of the University of California-San Diego and Hooper of Deutsche Bank Securities.
The Fed and other central banks cannot escape the economic consequences of their governments' indebtedness, they contend: "Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe ... countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics."
"Such feedback is left out of current long-term U.S. budget projections and could make it much more difficult for the U.S. to maintain a sustainable budget course," Mishkin and colleagues said. "A potential fiscal crunch also puts fundamental limits on what monetary policy is able to achieve."
The authors put the U.S. net debt as a percent of GDP, which excludes government securities held by the Social Security Trust Fund and other federal accounts, at 80.3% as of 2011, roughly double what it was a few years earlier.
They suggest the United States may already be on a "slippery slope" of fiscal deterioration from which it will be hard to retreat and which will make the Fed's job much more difficult. Other analysts have used 85% or 90% as the "fiscal crunch" or "tipping point."
The Congressional Budget Office recently projected the U.S. gross debt will rise to 107% next year from 103%, then decline modestly, before resuming a gradual ascent.
But the CBO assumes long-term interest rates will rise only gradually to 5.2% in 2018, and the economists say "this assumption could lead to a significant understatement of the potential deterioration in the budget picture because yields are assumed to hold steady at normalized levels as debt continues to accumulate." In fact, they say, yields "would rise even more than in the CBO projections."
Indeed "if the U.S. continues to pile on more debt and if we assume - as CBO does - a normalization of interest rates over the course of coming years (to roughly 4.0% for 3-month T-bills and 5.2% for 10-year notes), then debt service costs will skyrocket."
The CBO also assumes modest inflation in coming years, but the authors warn that "the path implied by baseline CBO projections could quickly become much more difficult to manage than some policy-makers may be assuming."
Compounding the problem of rising debt-to-GDP ratios and rising debt service costs is the large U.S. current account deficit, which is being financed by heavy borrowing abroad. By contrast, Japan has an even larger debt-to-GDP ratio, but has a current account surplus and a high rate of domestic savings.
Mishkin and his colleagues are not sanguine as they examine what all this means for U.S. monetary policy.
They note that, thus far, the Fed's large-scale asset purchases or "quantitative easing" have helped hold down interest rates, but they suggest it will be increasingly difficult for the Fed to conduct a prudent policy in the face of mounting debt, unless a "grand bargain" is reached between the White House and Congress.
Conceivably, the Fed could agree to keep rates low and delay the "exit" from accommodation, provided the fiscal authorities are making meaningful progress in reducing the deficit and the debt-to-GDP ratio.
But the authors are not hopeful, saying that "given a still polarized political system in the U.S., a less favorable outcome seems more likely."
If, instead, U.S. fiscal policy remains on an unsustainable course, they warn of an increasing risk of "fiscal dominance, where the central bank ultimately is forced to finance the fiscal deficit via inflation."
Barring a surprise agreement on a package of entitlement and tax reforms that puts the debt ratio on a downward path, U.S. fiscal policy "remains on a clearly unsustainable trajectory for the longer term," say Mishkin and his fellow economists. "Therefore, it seems safe to assume that sovereign risk remains alive and well in the U.S., and that it could very well intensify in the period ahead."
That could lead to some "ominous" scenarios, they warn.
"In the extreme, unsustainable fiscal policy means that the government's intertemporal budget constraint will have to be satisfied by issuing monetary liabilities, which is known as fiscal dominance, or, alternatively, by a default on the government debt," they write. "Fiscal dominance forces the central bank to pursue inflationary monetary policy even if it has a strong commitment to control inflation, say with an inflation target."
The Fed is buying $85 billion a month of Treasury and mortgage-backed securities through the creation of new bank reserves, and is incentivizing the banks to hold those "excess reserves" by paying them interest (the IOER), thereby, it hopes, keeping the new reserves from expanding the supply of money and credit and fuelling inflation.
But the authors suggest this strategy is doomed because "ultimately all the open-market purchase does is exchange long-term government debt (in the form of the initial Treasury debt) for overnight government debt (in the form of interest-bearing reserves) ... any swap of long-term for short-term debt in fact makes the government more vulnerable to ... a fiscal crunch, namely, more vulnerable to a self-fulfilling flight from government debt, or in the case of the U.S., to a self-fulfilling flight from the dollar." So-called fiscal dominance "puts a central bank between a rock and a hard place," the report says. "If the central bank does not monetize the debt, then interest rates on the government debt will rise sharply,
causing the economy to contract.
"Indeed, without monetization, fiscal dominance may result in the government defaulting on its debt, which would lead to a severe financial disruption, producing an even more severe economic contraction," it continues. "Hence, the central bank will in effect have little choice and will be forced to purchase the government debt and monetize it, eventually leading to a surge in inflation."
"We could already be seeing the beginning of this scenario in Europe," Mishkin and company write, citing the European Central Bank's stated willingness, through its Outright Monetary Transactions program, to buy the debt of countries that meet certain conditions.
"If the ECB does not do what ECB President Mario Draghi has described as 'doing whatever it takes' to lower interest rates in these countries, the alternative is deep recessions in these countries or outright defaults on their debt, which would create another 'Lehman moment' in which the resulting financial shock could send the Eurozone over the cliff," they write.
Although the U.S. is not yet at that precipice, in part because the federal government and the Fed do not take responsibility for the debts of the 50 states, the authors warn, "Nevertheless, the possibility of fiscal dominance is real given the federal budget and debt situation" and the apparent lack of political will to confront it.
"If U.S. government finances are not put on a sustainable path, we could see the scenario ... where markets lose confidence in U.S. government debt, so that bond prices fall and interest rates shoot up, and then the public might expect the Federal Reserve to be forced to monetize this debt," they warn.
"What would then unhinge inflation expectations would be the fear of fiscal dominance, which could then drive up inflation quickly," they go on.
Mishkin and his colleagues assert that the Fed's oft-stated commitment to "price stability" will avail it little in that scenario.
"The bottom line is that no matter how strong the commitment of a central bank to an inflation target, fiscal dominance can override it," they write. "Without long-run fiscal sustainability, no central bank will be able to keep inflation low and stable."
Complicating the picture is the Fed's annual remittances to the U.S. Treasury, which have grown to record levels in recent years as the Fed's portfolio of securities has ballooned. Last year, the Fed paid Treasury $88.9 billion.
Agreeing with the findings of a recent Fed staff paper, the report warns that "under some conditions, the Fed could suffer substantial net income losses as it exits its current extraordinarily accommodative policy stance in the years to come" - negating the Fed's substantial contributions to the federal budget.
"Given such concerns in what remains a remarkably calm fiscal environment (given near record-low Treasury yields), how much worse could the picture become if sovereign debt concerns heat up?" Mishkin and Co. ask. "And to what degree could U.S. monetary policy be constrained as a result?"
The Fed's net income could even turn negative and losses could exceed its capital, they warn. Then, not only would the Fed be unable to pay the Treasury, it would be unable to pay interest on reserves and meet other obligations in the normal way.
In that event, the authors say, the Fed has provided for a procedure under which it would create new reserves against a so-called "deferred asset" - essentially a claim on presumed, future Fed earnings.
In their baseline simulation, the economists estimate that "the deferred asset account would rise to a bit over $20 billion by 2018," before receding. But there are worse case scenarios.
To persuade banks to continue to hold excess reserves, the Fed will need to increase the rate of interest it pays on those reserves to prevent an inflationary surge of money into the economy. But doing so could, at some point, reduce or eliminate remittances to Treasury.
That "could bring Fed policy decisions under greater public scrutiny, potentially leading to controversy that could even threaten central bank independence," Mishkin and his colleagues warn.
The Fed's policymaking Federal Open Market Committee has regularly stated it will weigh "the likely efficacy and costs" of its bond buying. And well it might, the paper stresses.
They say "continued expansion of the Fed's balance sheet significantly raises the chances that the Fed will, for an extended period, cease to make positive remittances to the Treasury, especially if the Fed elects to sell some of its assets to speed up the runoff of excess reserves.
"In the presence of an unsustainable debt trajectory, political concerns surrounding any reduction in Fed remittances to the Treasury would be heightened," it continues. "And the effect of fiscal imbalance on interest rates would exacerbate this problem."
"The magnitude of the Fed's cumulative net income losses could be increased substantially - even approaching several times the size of Fed capital - if failure to deal with an unsustainable U.S. fiscal position in the longer term results in a sizable increase in the inflation risk premium on U.S. national debt."
That "might tend to push the Fed toward delaying its exit from the extraordinary easing measures it has taken in recent years; it could even affect decisions this year about how much further to expand the Fed's holdings of longer-term government securities," Mishkin and his colleagues write.
They say "the Fed could cut its effective drain on the Treasury significantly by putting off asset sales and delaying policy rate increases." But they warn "such a response would presumably feed rising inflation expectations."
"In brief, the combination of a massively expanded central bank balance sheet and an unsustainable public debt trajectory is a mix that has the potential to substantially reduce the flexibility of monetary policy," they warn. "This mix could induce a bias toward slower exit or easier policy, and be seen as the first step toward fiscal dominance. It could thereby be the cause of longer-term inflation expectations and raise the risk of inflation overall."
Although the CBO "assume constant borrowing rates as debt loads rise...," the authors warn that adverse market feedback could mean that "the problems facing the U.S. in the next decade could easily escalate into an unmanageable situation."
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