Will the Fed Know When to Say ‘When’?

Jack Ablin Market Commentary

Congress handed the keys to the monetary printing press to America’s central bank in 2008, when lawmakers granted the Federal Reserve the ability to pay interest on excess banking reserves. The move opened the door for the Fed to purchase virtually unlimited quantities of government and private securities with money borrowed from the banking system. The Dodd-Frank Act of 2010 freed the Fed from many of the regulatory checks and balances encumbering other agencies and opened the door to unprecedented monetary policy initiatives, like the $3.7 trillion purchase of government and private debt between 2008 and 2014. The legislation ushered in a decade-long economic and financial market recovery that, remarkably, ensued without inflation.

Fast-forward to today’s COVID-19 crisis. The Fed pumped more than $2 trillion into the economy shortly after the lockdown, more than twice as much it spent in the aftermath of the Lehman bankruptcy.  Moreover, the Fed committed to buy an additional $5 trillion of debt by the end of 2021, dwarfing its response to the financial crisis. Other central banks are joining the bond-buying binge. The European Central Bank announced $3.4 trillion of quantitative easing purchases, while the Bank of Japan and the Bank of England pledged a combined $1.5 trillion. Recent Fed purchases take America’s central bank into new policy territory. After the global financial crisis, monetary policymakers were leery of extending credit to companies not directly linked to the financial system, its regulatory domain. Today, the Fed is buying corporate bonds, including junk bonds, to ensure companies’ access to capital. Remarkably, the COVID-19 crisis has shown the Federal Reserve is the most potent agent of Washington, with the ability to dispense trillions and the agility to enact measures quickly. The Fed and its brethren have been able to exact their measures with financial impunity.

Textbook government debt cycles, in which gaping budget deficits are financed with government debt, are self-correcting. The new borrowing drives up interest rates, which quells subsequent borrowing. Under the new monetary regime, textbooks don’t apply: though government borrowing still finances budget deficits, central bank debt purchases keep a lid on higher rates, enabling the cycle to continue. The perception that the Federal Reserve has unlimited resources at its disposal whose deployment has no adverse economic consequences, like inflation, has emboldened proponents of Modern Monetary Theory who believe that not only can the Fed print money to buy bonds, they could also print money to build bridges, pay for healthcare or bail out beleaguered states.

Central bank money printing has not been without consequences. Holding down long-term interest rates below fair value has boosted equity and bond prices, making it cheaper for companies to raise capital and invest. The policy has provided an exaggerated benefit to Wall Street – holders of financial assets – while passing over Main Street. Governments worldwide have embraced the “don’t tax, just spend” strategy, by running up budget deficits. In 2009, the US budget hole represented 9.8 per cent of GDP. That number is expected to double this year, according to a recent report in Foreign Affairs.  Japan’s budget deficit is expected to be 8.5 per cent this year, the UK’s is expected to be 11.5 per cent and China’s is expected to be 12.3 per cent. The US is in the enviable position of having its debt denominated in a world reserve currency. The greenback has long enjoyed safe-haven status in times of stress. The dollar’s reserve status has enabled the US to enjoy a cascade of capital that keeps interest rates low and federal borrowing inexpensive.

How far can the cozy relationship between the Federal Reserve and the Treasury continue in their quest to paper over America’s economic imbalances? While the Fed’s printing power appears unlimited, the federal government’s ability to borrow is constrained by a combination of the debt-to-GDP ratio, the nominal GDP growth rate and the interest rate it pays on its debt. As long as nominal growth outpaces borrowing rates, Washington could theoretically grow its way out of its debt problem provided that it gets its budget under control. Cresset estimates that America’s real sustainable GDP growth rate is 1.7-2 per cent, assuming 0.5 per cent annual growth of the labor market and a 1.5 per cent annual productivity gain. Using the market’s estimate, future inflation is gauged to be around 1.8 per cent, implying a 3.3 per cent sustainable nominal GDP growth rate. Using a 3.3 per cent nominal growth rate paints a problematic picture, assuming we continue to run a federal budget deficit approaching 10 per cent of GDP. Our current trajectory expands government debt to 200 per cent of GDP by 2030. Cutting the federal budget deficit in half, to roughly 5 per cent of GDP, buys us time: under that scenario we reach a 148 per cent debt-to-GDP ratio by 2038.

Japan’s debt experience emboldens America’s “don’t tax, just spend” mentality. The country’s debt-to-GDP ratio surpassed 100 per cent in 2000, and is nearly double that level today. Yet Japan has not experienced a debt crisis. In fact, the yen remains a safe-haven currency. Moreover, Japan’s cost of servicing its debt has declined over the years, thanks to a steady decline in its 10-year benchmark yield.  Now at 0.1 per cent, Japan’s JGB yield slid from 1.8 per cent when Japan’s debt level crossed 100 per cent of GDP.

In the context of Japan, America’s debt capacity is broad, particularly if we use a more realistic 3.3 per cent nominal growth rate and benchmark Treasury rates stay below 1 per cent. Several risks should be noted, however. First is the federal budget deficit. Notwithstanding today’s COVID-19 challenges, running a budget deficit approaching 10 per cent of GDP is unsustainable. Trimming it to 5 per cent of GDP provides a substantially longer runway, as our study shows. Another risk is the benchmark Treasury yield, the rate the government pays on its debt. Anything that ratchets the rate higher, like inflation, could undermine America’s borrowing strategy. We believe the likelihood of substantially higher US interest rates to be remote as long as the dollar remains the world’s principal reserve currency.