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The Federal Reserve’s massive bond buying to stabilize financial markets in the wake of the coronavirus pandemic does not change the fact that the U.S. still has to deal with a mountain of debt, warned former IMF chief economist Ken Rogoff.
Noting the Fed’s willingness to expand its balance sheet has helped to convince market participants to keep buying U.S. Treasury debt as the fiscal deficit soars, Rogoff said the central bank’s purchases did not change the overall stock of public debt.
“It’s absolute smoke and mirrors. There’s almost zero difference from the Fed buying long-term Treasury debt and having the Treasury issue short-term bonds,” said Rogoff, in an interview. “I think people forget that the Treasury owns the Fed.”
He argued the Fed and Treasury’s balance sheets needs to be combined. In essence, if the Fed bought government bonds and received interest-bearing bank deposits, the bonds should still count as government debt.
The Congressional Budget Office has estimated that the fiscal deficit will rise to about $3.7 trillion this fiscal year or about 18% of GDP. The federal debt held by the public is also seen rising to more than 100% of gross domestic product from about 80% at the end of last fiscal year.
The Federal Reserve’s balance sheet grew to a record $6.98 trillion in the week ended May 13, up from $6.72 trillion in the prior week.
See: Latest on Fed’s expansive rescue programs to keep credit flowing during the coronavirus pandemic
Rogoff’s remarks come as bond-market analysts suggest investors are unlikely to demand vastly higher yields to absorb the U.S.’s multi trillion dollar fiscal deficits this year. Though that is the case for now, that may not be the situation forever.
“The debt is not a free lunch. The question is what happens to real interest rates. The market thinks it’ll never go up again and I think that’s a bit naive,” Rogoff added.
“There is a presumption in markets for a long time that any shock will bring interest rates down. That’s been the trend, but we just have no idea where we’re going after this. There’s a definite risk there will be pressure some day,” he said.
But at the moment, Rogoff said, there was no immediate pressure in the form of higher inflation-adjusted, or real, interest rates to bring the debt load under control.
The Treasury’s cost to borrow over the next decade TMUBMUSD10Y, 0.685% stood at 0.70%, down from around 2% at the start of the year. This leaves the inflation-adjusted rate at around a negative 0.48%, based on trading in Treasury inflation-protected securities.
Some have seen inflation as the specter that will come to haunt the 40-year long bull market in Treasurys, but Rogoff was skeptical price pressures were around the corner especially since the Fed is reluctant to employ negative interest rates.
In the event that inflation-adjusted bond yields did rise sharply, he suggested the central bank could return to the postwar playbook of financial repression, keeping down the government’s debt expenses through caps on interest rates or financial regulations.
Rogoff questioned the belief that the U.S.’s ballooning public debts would not be a problem amid the growing popularity of Modern Monetary Theory, which argues developed countries that borrow in their own currency had a higher capacity for fiscal deficits than assumed.
Opinion: Modern Monetary Theory is smoke and mirrors nonsense
He acknowledged the U.S. was in a unique position, but other countries didn’t enjoy a similarly favorable set-up.
For example, if Indonesia issued government bonds in the rupiah, its businesses still had to borrow in greenbacks in a global financial and commercial system dominated by the U.S. dollar. Though a lower exchange rate may not increase its fiscal burden, it would, however, ravage companies that had borrowed cheaply in the dollar and make it more expensive for households to buy imported goods.
The S&P 500 SPX, +1.66% and Dow Jones Industrial Average DJIA, +1.53% were rising on Wednesday, while the Nasdaq Composite COMP, +1.98% came within a few percentage points away from its all-time high of 9,838.37.
