Jerome H Powell: Discussion of "Crunch time - fiscal crises and the role
of monetary policy"
Speech by Mr Jerome H Powell, Member of the Board of Governors of the Federal Reserve
System, at the "US Monetary Policy Forum" conference, sponsored by the University of
Chicago Booth School of Business, New York City, 22 February 2013.
* * *
The issue of fiscal sustainability and its interaction with monetary policy is certainly timely.1
Many advanced economies are in an extended period of slow growth and high deficits, and
face long-term fiscal pressures from aging populations.
I agree with much in this broad-ranging paper.2 In particular, the authors join others in finding
that accommodative monetary policy is often associated with successful fiscal
consolidations. They conclude that a "tough love" alternative, which would call for the Federal
Reserve to withhold monetary accommodation until fiscal policymakers enact legislation to
reduce budget imbalances, is likely to be counterproductive. Indeed, I would argue that the
tough love approach also would require the Fed to deviate from the dual mandate that the
Congress has assigned it, while assuming a role in influencing fiscal policy that the Congress
has not assigned it.
I find myself in disagreement, however, with the paper's assessment that the current fiscal
policy challenges might interfere in the near-term with the conduct of monetary policy in the
United States.
Three important propositions underlie the authors' argument on this issue:
1. The federal government's fiscal path is unsustainable under current policies.
2. If the market concludes that a government either cannot or will not service its debt,
the central bank may be forced to choose ultimately between monetization leading
to inflation or standing by as the government defaults - the threat of "fiscal
dominance."
3. The Federal Reserve's balance sheet is currently very large by historical standards
and still growing. The process of normalizing the size and composition of the
balance sheet poses significant uncertainties and challenges for monetary
policymakers.
I believe all of these statements to be true. They are also widely, if not universally, accepted.
However, based on these points and, importantly, on their empirical findings, the authors set
out to show that fiscal difficulties present a near-term threat to the conduct of monetary
policy. The paper argues that rising fiscal pressures, exacerbated by Federal Reserve losses
on asset sales and low remittances to the Treasury, could lead the Federal Reserve to delay
balance sheet normalization and to fail to remove monetary accommodation as needed to
keep inflation expectations stable and inflation in check. In that case, the market could
perceive the onset of fiscal dominance, thus setting off a vicious cycle of rising inflation
expectations, increasing interest rates, and ever greater fiscal unsustainability.
In my view, this proposition seems highly unlikely. At a minimum, it is premature.
U.S. fiscal position
The paper led me to look back over the past century of U.S. sovereign debt history. On two
prior occasions, federal debt as a percentage of gross domestic product (GDP) increased
significantly - during the Great Depression-World War II era and, to a smaller extent, the two
decades ending in the mid-1990s.3
After each of these high-debt periods, fiscal policy responded by running sustained primary
surpluses and reducing debt to levels below 40 percent of GDP. In a recent paper, Henning
Bohn observed that "the foundation of U.S. debt policy is the promise of safety for
bondholders backed by primary surpluses only in response to a high debt-GDP ratio."4 That
nicely captures our recent history and suggests a principal reason why the federal debt of the
United States still has the market's trust.
The Great Recession has generated a third substantial increase in federal debt, from about
35 percent of GDP in 2007 to around 75 percent at the end of this fiscal year, an increase
that is consistent with other increases in sovereign debt for advanced economies after
severe financial crises during the post-World War II period.5 History and common sense
suggest that the federal government should again run primary surpluses sufficient over time
to reduce debt to pre-crisis levels of perhaps 35 to 40 percent of GDP. That would leave
fiscal space to address the coming wave of health and pension costs, as well as unexpected
new shocks.
In the past two years, spending cuts and tax increases totaling about $3.5 trillion over the
next 10 years have been enacted. Assuming these measures are not rolled back - in
particular, that the spending sequestration either takes effect or is replaced by equivalent
deficit-reducing measures - a reasonable "current policy" projection is that the ratio of debt to
GDP will be roughly stable at around 75 percent through about 2020.6 After that, under
current policy, health-care costs and, to a much lesser extent, pension costs will produce a
sharp, sustained increase in the ratio of debt to GDP.
Fiscal sustainability and monetary policy
The authors review empirical evidence of sovereign borrowing costs for 20 advanced
economies. They join others in finding a statistically significant relationship between
sovereign debt levels and borrowing costs.7 They also find nonlinear increases in borrowing
costs beginning at debt-to-GDP ratios of around 80 percent. But the nonlinearities they find
are driven to a great extent by the experience of smaller euro-zone nations that, of course,
3
Figure 1 shows federal debt held by the public and primary budget surpluses - that is, the difference between
federal revenues and federal noninterest outlays - as a percent of nominal GDP from fiscal year 1912 through
fiscal 2012.
4
See quote on p. 290 in Henning Bohn (2011), "The Economic Consequences of Rising U.S. Government
Debt: Privileges at Risk," FinanzArchiv/Public Finance Analysis, vol. 67 (September), pp. 282-302.
5
See Carmen M. Reinhart and Kenneth S. Rogoff (2009), "The Aftermath of Financial Crises," American
Economic Review, vol. 99 (May), pp. 466-72.
6
See Loren Adler, Shai Akabas, and Brian Collins (2013), "Key Takeaways from the 2013-2023 CBO Budget
and Economic Outlook," Bipartisan Beat Blog, Bipartisan Policy Center, February 7. Numbers are modified to
assume that the spending sequestration either takes effect or is replaced by equivalent deficit reducing
measures.
7
For example, see Eric Engen and R. Glenn Hubbard (2005), "Federal Government Debt and Interest Rates,"
in Mark Gertler and Kenneth Rogoff, eds., NBER Macroeconomics Annual 2004, vol. 19 (Cambridge, Mass.:
MIT Press), pp. 83-138; Thomas Laubach (2009), "New Evidence on the Interest Rate Effects of Budget
Deficits and Debt," Journal of the European Economic Association, vol. 7 (June), pp. 858-85; and
Joseph W. Gruber and Steven B. Kamin (2012), "Fiscal Positions and Government Bond Yields in OECD
Countries," Journal of Money, Credit and Banking, vol. 44 (December), pp. 1563-87.
borrow in euros. The United States borrows in its own currency - the world's primary reserve
currency. That difference is crucial for investors, along with the fact that the United States
economy remains the world's largest and most productive. The United Kingdom and Japan
are also high-debt countries that borrow in their own currencies; neither shows any
detectable rate increase, let alone a nonlinear one. These countries present a serious
problem for the authors' case.
Of course, the United States is not exempt from concerns about the potential long-term
effects of an unsustainable fiscal path. There is almost certainly a level of debt at which the
United States would be at risk of an interest rate spike. However, we should expect that level
to be substantially above one identified based on the experience of smaller euro-zone
nations.
The argument also has a serious timing problem. 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. Under the reasonable projection mentioned above, the
debt-to-GDP ratio will remain roughly stable until 2020 before rising significantly in the next
decade.8 That's not a favorable longer-term forecast, all the more so because it is importantly
the result of demographic changes that have been expected for decades. But the forecast
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.
No current market signal suggests that the United States is near the point of losing the
market's confidence. In my view, nothing in the Congressional Budget Office debt forecasts
or the authors' empirical findings provides grounds for such an event during this decade. The
market has every reason to believe - and apparently still does believe - that the United
States will continue the difficult task of fiscal consolidation until the job is done.
Terribly difficult fiscal adjustments lie ahead. Although there is still time to make them, delay
will sharply increase the pain of adjustment. The time to act is now. In my view, the problem
is not principally one of economics or fiscal policy; it is one of governance. The real threat to
the fiscal standing of the United States is that of inaction caused by a long period of political
polarization and dysfunction. That would be a self-inflicted wound. And that is a problem that
can't be derived from the traditional fiscal metrics.
We may have more room than other economies around the globe, but I do not intend to
project any sense of complacency around this topic. The authors' basic message seems just
right to me: We don't know where the tipping point is; wherever it is, we are clearly getting
closer to it, and the costs of misestimating its location are enormous and one-sided. The
benefits to long-term fiscal consolidation - conducted at the right pace, and without
jeopardizing the near-term economic recovery - would be substantial.
Balance sheet losses and remittances
The authors' work on Federal Reserve income and remittances to the Treasury overlaps with
a paper published last month by Federal Reserve Board staff members Seth Carpenter, Jane
Ihrig, Beth Klee, Daniel Quinn, and Alexander Boote.9 Both papers provide a basis for public
discussion of these matters, which is a highly positive development. Some of the assets
acquired through the Federal Reserve's large-scale asset purchases (LSAPs) may be sold at
a loss, and it is important to be transparent about this possibility.
Thus far, the Federal Reserve's asset purchases have greatly increased our income and
remittances to the Treasury. Indeed, remittances have run at an annual level of about
$80 billion from 2010 to 2012. Both papers show that remittances are likely to decline
substantially from these elevated levels as interest rates rise and the Fed balance sheet
normalizes, and there may be a period of zero remittances. If so, the balance sheet would
show a deferred asset representing a flow of future income to be retained and not remitted to
the Treasury. Nonetheless, we expect that the LSAPs, which began in late 2008, will result in
a net increase in remittances over the life of these programs. Moreover, 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.
Greenlaw and his coauthors also note that we have the flexibility to normalize the balance
sheet more slowly. For example, a "no asset sale" plan - under which assets would simply
run off as they mature - would push out the date of normalization by only a year or so. That
approach would also address concerns over potential market disruption from the sale of
off-the-run agency mortgage-backed securities. And it would also smooth remittances.
Remittances averaged about $25 billion per year, or 0.2 percent of GDP, over the decade
before the crisis. After the balance sheet is normalized, these remittances should return to a
similar, modest share of GDP. From the standpoint of the sustainability of federal fiscal
policy, remittances are not a first-order concern. That said, an extended period of zero
remittances could certainly bring the Federal Reserve under criticism from the public and the
Congress. The question is whether the Federal Reserve would permit inflation and thereby
abandon its post in the face of such criticism. There is no reason to expect that to happen.
The Federal Reserve was created as an independent agency, and a broad consensus has
emerged among policymakers, academics, and other informed observers around the world
that better overall economic performance is achieved when the conduct of monetary policy is
free from political control.10 Of course, we are accountable to the Congress and the American
people. The Congress has given us a job to do, and as long as I am a member of the Federal
Reserve Board, I will do my utmost to carry out our mandate.
Other observations
The authors note that Federal Reserve asset purchases shorten the duration of debt held by
the public, by the issuance of reserves to fund purchases of long-term securities. And
shortening the maturity of the public debt does make any government more susceptible, in
theory, to fiscal dominance. There is also a general assumption that under fiscal dominance
any government has a strong incentive to allow inflation to reduce the real value of the debt.
In the case of the United States, there is less to that than one might expect. By shortening
the duration of debt held by the public, asset purchases have also reduced any benefit to the
government of an unexpected inflation. More fundamentally, the liabilities that matter in the
long term for the federal budget are those associated with health care and pension costs.
These liabilities are not nominal but real, and cannot be inflated away.
Conclusion
I am not suggesting, and I do not expect, that the path ahead for monetary policy will be an
easy one. There are legitimate concerns associated with the costs and benefits of continuing
asset purchases. We may face challenges related to financial stability, as well as market
function and inflation expectations. I do not personally see fiscal dominance as high on the
list of near term risks.
I thank the authors for their interesting work.