Federal Reserve Chair Jerome Powell initiated a program of quantitative easing (QE) in March. QE programs have typically combined monetary expansion with the payment of interest on excess reserves to offset the expansion’s influence on economic activity. But, unlike past QE programs, Powell’s expansion has allowed for an increase in M2 of more than 18 percent.
The aggressive expansion supported price increases after a sharp decline in annualized inflation of 5 percent in March and nearly 10 percent in April. In June, annualized inflation rose above 6 percent, a stark reversal. If this trend continues for a few months, Powell must make a choice. As nominal income returns to trend, owing largely to support from monetary policy, Powell will either have to increase interest rates or else allow inflation to increase. While allowing interest rates to rise might be painful in the short term, allowing inflation to get out of hand could unanchor inflation expectations, leading to irreversible damage.
Bernanke and Yellen never faced such a dilemma. They successfully prevented the expansion of the monetary base from affecting the quantity of money as measured by M1 or M2. Powell’s Fed has initiated a program of direct lending to businesses. It has also supported fiscal expansion that resulted in the disbursement of stimulus checks and expansion of unemployment benefits, much of which has been saved by recipients.
As the recent surge of COVID-19 cases moves past its peak, states will resume reopening. Business activity will return. And, as expectations improve, people will begin spending the funds they are currently holding. If Powell is to prevent inflation from taking off, he will have to assure the market that he will not continue monetary easing that supports low interest rates.
In the not-so-distant future – likely before the end of the year – Powell will have to allow interest rates to rise. If he does not, investors will likely interpret the increase in M2 as a lack of concern for inflation. Powell has expressed a commitment to easing and has called for continued fiscal support as a recovery has not quite taken off. Larger debt entailed in fiscal support, however, places the Federal Reserve, the U.S. Treasury, and the economy at large in a precarious position.
The federal government, with support from the Fed in the form of QE, has continued increasing its debt burden. Federal debt now exceeds $26 trillion. By comparison, nominal GDP in 2019 was $21.7 trillion and annualized GDP was $19.4 trillion in the second quarter of 2020.
If interest rates rise, the burden of U.S. debt will increase significantly. An average rate paid on government debt of just 5 percent would amount to more than $1 trillion in annual interest payments. Considering that the federal government typically collects tax revenue whose value is between 15 to 20 percent of GDP, a 5 percent rate would dedicate a quarter to one-third of tax revenues to the payment of interest on the national debt. Rates in excess of 5 percent, though less likely, would be significantly more painful.
Financial markets are beginning to express concern. Fitch recently revised its scoring of the U.S. from stable to negative, though the rating currently remains at Fitch’s highest level, AAA. S&P ratings downgraded U.S. debt to AA+ in 2011, so we aren’t exactly in uncharted territory. But the addition of another demerit is not encouraging.
The U.S. dollar index has also been steadily declining over the last few months. Perhaps it is just an uneventful blip in the data. But it is worth considering the potential downside risks that the current fiscal-monetary arrangement entails.
Monetary Policy and Inflation Expectations
Double-digit inflation, while unlikely, would unanchor inflation expectations. And, as we learned from Paul Volcker’s tenure, reestablishing that anchor is not easy. Volcker was only able to tame inflation expectations by leaning against the wind, allowing the federal funds target to rise alongside inflation expectations. The policy, while effective, came at a high cost. The unemployment rate increased from 6.0 percent in August 1979 to 10.8 percent in December 1982,and it remained above 6.0 percent until August 1987.
Sooner or later, Powell will have to choose. He will either allow interest rates to rise as outlook improves, thereby ending an unprecedented level of support for federal spending. Or, he will attempt to maintain historically low interest rates and risk inflation getting out of hand. And, if inflation were to really get out of hand, the dollar could lose its status as the international reserve currency.
To be clear: it seems unlikely that the world will abandon the dollar anytime soon, especially if Powell credibly commits to enacting a policy aimed at monetary stability rather than one that prioritizes fiscal expansion. But, if it were to happen, dedollarization would exacerbate the problems Powell—and America—faces considerably.
As it stands, Powell seems unwilling to raise rates. He recently announced that he will maintain the current level of support with short-term rates near 0 percent.
Inflation under a Regime of Unconventional Monetary Policy
The current system of unconventional monetary policy depends on the ability of the Federal Reserve to pay relatively low rates of interest to prevent base money from entering the financial system. At relatively low interest rates, this position is trivial. Payment of interest on excess reserves is the equivalent of no more than 1 or 2 percent of the circulating base at present.
If interest rates were to rise, however, the Federal Reserve would have to pay banks more to prevent the money it has created from multiplying throughout the banking system. And if rates were to rise a lot, the Fed would have to pay banks a lot more.
The current level of excess reserves amounts to over $3 trillion—more than 150 percent of the quantity of base money in circulation. Suppose the Fed had to pay banks a rate of 10 percent to hold excess reserves over the period of a year. The interest payment would be equal to 15 percent of the currency in circulation. Powell would either need to draw this amount from the Federal Reserve’s revenues or increase the quantity of base money even further to pay sufficient interest. If drawing from revenues is not viable (a likely scenario in the case of double-digit inflation rates), the situation could easily spiral out of control: the Fed would have to increase the quantity of base money to prevent the existing supply from entering circulation, which would then require an even greater increase in the quantity of base money in the next period, and so on.
Unconventional monetary policy only works if inflation expectations remain anchored. And inflation expectations only remain anchored if the public expects that the federal government will honestly repay its debts. The position of the federal government is not yet unmanageable, but we are closer to a crisis than seems prudent.
If Powell’s Fed does not raise rates after reopening gains speed or if the federal government does not put its finances in order – these two factors are not independent – investors’ appetites for U.S. dollars and dollar-denominated debt may swiftly abate. And, once there is a breach of faith, trust is difficult to repair. Unlike during the inflationary episode of the late 1970s and early 1980s, the current level of federal expenditures is much too large to be supported without monetary debasement if interest rates rise to double digits.
Jerome Powell and those steering fiscal policy choose from two paths: fiscal responsibility or monetary debasement. If he is unable to maintain stable expectations of low inflation, the latter path awaits.