Four economists, including a former Federal Reserve governor who has co-written research with Chairman Ben S. Bernanke, warned that losses from the central bank’s more than $3 trillion balance sheet could lead to the Fed losing control of monetary policy.
“The combination of a massively expanded central bank balance sheet and an unsustainable public debt trajectory is a mix that has the potential to substantially reduce the flexibility of monetary policy,” the economists write. “This mix could induce a bias toward slower exit or easier policy, and be seen as the first step toward fiscal dominance. It could thereby be the cause of longer-term inflation expectations and raise the risk of inflation overall.”
The conclusion from economists, including Frederic Mishkin, a governor at the central bank from 2006 to 2008 and an academic collaborator with Bernanke before that, will be presented at the U.S. Monetary Policy Forum in New York. Their paper serves as a high-profile warning to an audience including Boston Fed President Eric Rosengren, Fed Governor Jerome Powell and St. Louis Fed President James Bullard.
The central bank is currently purchasing $85 billion a month of Treasuries and mortgage-backed securities, following two previous rounds totaling $2.3 trillion, in an effort to lower an unemployment rate stuck near 7.9 percent. Once the economy strengthens, the central bank plans to unwind its balance sheet by raising interest rates and selling many of the assets acquired over the past four years.
The economists say that the Fed could incur substantial losses that might occur when U.S. deficits are still high and Congress and the White House have been unable to put fiscal policy on a sustainable trajectory.
“This unfavorable fiscal arithmetic might tend to push the Fed toward delaying its exit from the extraordinary easing measures it has taken in recent years; it could even affect decisions this year about how much further to expand the Fed’s holdings of longer-term government securities,” the authors said. “The Fed could cut its effective drain on the Treasury significantly by putting off asset sales and delaying policy rate increases. But such a response would presumably feed rising inflation expectations.”
The U.S. Monetary Policy Forum is sponsored by the Initiative on Global Markets at the University of Chicago Booth School of Business.
In addition to Mishkin, now an economist at Columbia University, the authors of the paper are David Greenlaw, chief U.S. fixed income economist for Morgan Stanley; James D. Hamilton, a professor of economics at the University of California in San Diego; Peter Hooper, chief economist at Deutsche Bank Securities Inc.
Hooper and Greenlaw are both former Fed economists, while Hamilton’s research on bond yields has been cited by Bernanke as justification for the Fed’s policies.
The Federal Reserve recently released a paper showing that the income it has traditionally earned from its policies could disappear for years as interest rates rise. After paying its expenses, the central bank returns any surplus to Treasury to help fund the expenses of the U.S. government. In 2012, the Fed returned $88.9 billion to taxpayers.
The Congressional Budget Office forecasts that the government will run deficits averaging nearly $700 billion from 2014 to 2023 in its baseline scenario.
“The bottom line is that no matter how strong the commitment of a central bank to an inflation target, fiscal dominance can override it,” the authors of today’s paper warned. “Without long-run fiscal sustainability, no central bank will be able to keep inflation low and stable.”
Fiscal dominance refers to a situation in which a central bank is forced to purchase government debt and finance deficits through inflation. If the central bank does not do this, interest rates will rise and the economy will contract and the government could even default, leading to a crisis that would cause an even worse contraction, the authors say. The central bank “will in effect have little choice,” they write.
The Fed aims for 2 percent inflation in the longer term and has said an outlook for inflation above 2.5 percent may prompt it to raise interest rates. The Labor Department said yesterday that prices rose 1.6 percent in January.
Investors in Treasury Inflation-Protected Securities expect that price increases will accelerate in coming years. Inflation will rise 2.5 percent per year, as measured by the spread between nominal and inflation-protected securities.
“While fiscal dominance is not an immediate risk, there are important elements in the current makeup of U.S. fiscal and monetary policy that suggest increasing attention will be paid to this risk in the years ahead,” the authors said.