Fed's Powell: Fiscal Dominance of Monetary Policy Not High on Risk List

Fears that mounting levels of federal debt will force the Federal Reserve into inflationary policies are probably overwrought, Fed Governor Jerome Powell said Friday.

Although the federal government needs to begin "now" to bring deficit spending and in turn the ratio of debt to GDP under control, "fiscal dominance" of monetary policy should not be seen as a big near-term risk, Powell said in prepared remarks at a Monetary Policy Forum sponsored by the University of Chicago's Booth School of Business School.

Powell conceded the Fed could incur some losses on its growing portfolio of Treasury and mortgage backed securities and that its annual remittances to the U.S. Treasury could dwindle to zero. But he said those costs must be "weighed against the expected social benefits" of the Fed's large-scale asset purchases (LSAPs).

Powell was one of two Fed officials responding to a paper by former Fed Governor Frederic Mishkin and other economists warning of the Fed's vulnerabilities to capital losses as its portfolio of Treasury and mortgage backed securities grows.

The other was Boston Federal Reserve Bank President Eric Rosengren, who also emphasized the benefits rather than the costs of so-called "quantitative easing."

The paper warned the federal government is on an unsustainable fiscal path; that this may force the Fed into inflationary debt monetization, and that the growing debt will make it very difficult politically to reduce the size of its balance sheet.

While agreeing that Mishkin, Morgan Stanley economist David Greenlaw and other co-authors have valid concerns, Powell said the proposition that fiscal pressures will cause the Fed to delay or fail to remove monetary stimulus in time to prevent accelerating inflation is "highly unlikely" or at least "premature."

Powell expressed confidence he debt to GDP ratio, now about 75%, will be brought back down to the pre-crisis level of 35-40% at some point. In the meantime, he said a "reasonable" projection is that the ratio will stay around 75% through 2020.

After that, rising health care and pension costs "will produce a sharp, sustained increase in the ratio of debt to GDP" if adjustments are not made, but by then the Fed will have reduced the size of its balance sheet and obviated the problems raised by Mishkin and his colleagues, he said.

"The Federal Reserve's balance sheet likely will be normalized by late this decade, before the federal debt-to-GDP ratio even increases materially from today's level."

The forecast that the debt-to-GDP ratio will stay around 75% through 2020 "doesn't support the authors' claim that fears of fiscal dominance could materialize in the United States within the next five to seven years, during the period when the Fed is normalizing its balance sheet," he said.

Besides, Powell said, "no current market signal suggests that the United States is near the point of losing the market's confidence."

Powell pointed out that, unlike other countries, the United States has the benefit of being able to borrow in the world's leading reserve currency. The ability to borrow in dollars should hold down Treasury borrowing costs.

"There is almost certainly a level of debt at which the United States would be at risk of an interest rate spike," he said. "However, we should expect that level to be substantially above one identified based on the experience of smaller euro-zone nations."

As rates rise, some Fed assets "may be sold at a loss," and "there may be a period of zero remittances" from the Fed to the Treasury," Powell conceded. But he said "any temporary losses should be weighed against the expected social benefits of the increased economic growth generated by the LSAPs, which would include higher tax revenue from increased output."

Powell noted the Fed can reduce the size of its balance sheet without selling assets just by letting them run off as they mature.

As the balance sheet shrinks, Fed remittances to Treasury will likely fall from around $80 billion per year to more like $25 billion - the pre-crisis level, he said. But while Congress may not be happy with this reduction in revenue, "there is no reason to expect" that the resulting political pressure will lead the Fed to permit higher inflation.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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