Central Banks

Friday, February 22, 2013 - 10:15

Ex-Fed Gov Mishkin,Economists Warn Fiscal Mess Cld Cripple Fed


-Report Warns Fed in Danger of Fiscal Dominance -Losses Could Slash Fed Remits to Treasury, Cause Policy Problems -Could Be Forced Into Debt Monetization, Infl; Warns Of 'Flight From the Dollar'

NEW YORK CITY (MNI) - - 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 raio.

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."

-more-

--MNI Washington Bureau; tel: +1 202-371-2121; email: sbeckner@mni-news.com

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