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Federal Reserve Chairman Jerome Powell
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Chairman Jerome Powell recently announced the Federal Reserve would tolerate periods of inflation above 2% to compensate for failing to reach that goal much of the last two decades. However, the Fed’s role in financing record federal deficits and the globalization of markets for U.S. securities have stolen the Fed’s policy-making clout.
During World War II, the Fed kept interest rates low to enable the Treasury to finance huge deficits. Afterward, the Treasury continued to pressure the central bank to accommodate its financing needs, and inflation was about 8% in 1950. The 1951 Treasury-Fed Accord freed the Fed to conduct an independent monetary policy.
Until the Global Financial Crisis, the Fed largely implemented policy by buying and selling very short-term government securities to target the federal funds rate—the rate banks charge each other for overnight loans.
Movements in that rate tended to shift the yield curve up for all Treasuries and for corporate bonds, mortgages and other consumer loans. What consumers paid for auto, home and credit card loans and businesses paid for debt financing were influenced by market expectations for economic growth and inflation, but the Fed could shift those medium and long-term rates up or down by adjusting the federal funds rate.
Through ascent of OPEC in the 1970s, the Fed appeared to worry more about unemployment than stable prices. Inflation fluctuated but gradually ratcheted up to double-digit levels.
Paul Volcker became chairman in 1979 and broke the cycle by sharply pushing up interest rates and unemployment. That recession helped Ronald Reagan defeat Jimmy Carter but until the Global Financial Crisis, the federal funds rate, supplemented by sage communications from the chairman, remained the primary policy tool.
Over the decades, a well-managed currency and strong economic growth made the dollar the dominant currency in global trade and investment, even when American sales or purchases are not involved. Dollar assets became the safe haven for foreign portfolio investment.
Foreign official and private long-term holdings of U.S. securities—Treasuries, mortgage-backed securities, and corporate bonds and stocks—have grown to $6 trillion and $15 trillion. However, now the Fed can influence long rates much less when it raises the federal funds rate—limiting the potency of its historically most important monetary policy tool.
When Ben Bernanke raised the federal funds rate in 2004-2006, longer-term Treasury rates hardly budged, and when the Fed pushed up short rates three times in 2015-2017, long rates were similarly stubborn.
To dig us out of the Great Recession, President Barack Obama and Congress pushed federal deficits to then record levels—$1.4 trillion in 2009 and $5.1 trillion over four years. The Fed printed dollars and purchased securities totaling $3.6 trillion—effectively monetizing 70% of those deficits.
COVID-19 relief measures and stimulus spending have pushed the FY 2020 deficit to $3.3 trillion, and the Fed’s balance sheet has increased by about $3 trillion—roughly 90% of the deficit. It has embraced radical measures such as purchasing corporate and municipal bonds and lending directly to private actors, and the Fed now owns about 30% of mortgage- backed securities. Again, the Fed has monetized federal deficits by buying Treasuries and mortgage-backed securities, and signaled those purchases will continue.
Since March that has pushed the 10-year Treasury TMUBMUSD10Y, 0.659% rate below 1% but inflation expectations are rising, and international investors have started piling into bonds denominated in Chinese yuan USDCNH, +0.08%, now perceived as safe, to earn higher yields.
The foreign currency value of the dollar has weakened BUXX, +0.26%, and investors are fleeing to gold GOLD, -0.85% too.
Had the Fed not acted, rates on 10-year Treasuries, auto loans and mortgages would have moved up and braked the recent recovery, because there is a limit to the tolerance among international investors to accommodate massive U.S. borrowing.
The lessons from all this are that the Fed can’t raise interest rates when it chooses to combat inflation. It must finance huge federal deficits that weaken confidence in the dollar, and the Chinese yuan is emerging as a genuine rival to the dollar.
Fed monetary policy independence is gone, massive federal deficits threaten the dollar’s status as the global currency, and the Chinese yuan is waiting in the wings.
Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
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