The Fed’s Balancing Act

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Marc Seidner:

Let's talk a bit about debt dynamics. We touched on inflation.

Text on screen: Marc P. Seidner, CIO Non-traditional Strategies

I think many will observe as we look back that it's actually fiscal policy that had a big impact or played play part in the inflationary episodes of ‘22 and 2023. Deficits are greater structurally than they've been pre-pandemic. Debt to GDP ratios are forever increasing. What are the implications for monetary policy of fiscal policy, deficits, debt dynamics? Does it affect the way the Federal Reserve will think about monetary policy? And perhaps most importantly, does it constrain monetary policy if there were to be a recession or a downturn, again, picking up on some of the risks that you pointed out, that may be more pronounced than might be consensus today?

Dr. Ben Bernanke:

Well, I think it might be useful to start off by saying that the federal government is not a household that has to balance its books every week, every month.

Text on screen: Dr. Ben Bernanke, Former Fed Chairman and Senior Advisor to PIMCO

You mentioned the debt to GDP ratio, because GDP is growing, the government can run a deficit pretty much indefinitely. So getting to a balanced budget is not necessarily a priority.

A certain amount of deficit is acceptable. However, we are beyond that point now, and the debt to GDP ratio is rising and is expected to rise further. That's a product of a variety of forces. On the one hand, the so-called entitlements, Social Security and particularly Medicare are a burden on the spending side. And then on the tax side, there’s been tax cuts and the discussion of future tax cuts and so on. So that needs to be, I think, thought about. And the good news for us so far is that international investors still seem willing to hold U.S. treasuries and at reasonable yields. That might not always be true. And that's a reason to be at least thinking about how to get on a better trajectory. Now, in terms of the Fed, the Fed is mostly interested in the relatively short term.

It's not looking at 10, 15 year horizons most of the time. And I think as long, for the near term, as long as international markets are absorbing the U.S. treasuries, the Fed will operate as usual more or less. And in the longer term, if the Fed remains independent, which of course will be a high priority for it, and if there is at least some movement towards getting us onto a sustainable trajectory, I think the Fed will be able to manage inflation and do monetary policy more or less as it's done for the last few decades.

I think the risks are that we don't get on a sustainable path, and at some point we start to get much less willingness of investors to hold treasuries. We start to see some overheating in the economy. Then a lot depends on whether the Congress lets Fed be independent or not. Let's say they do. But even in that case, the Fed would have to raise interest rates to keep the economy from overheating and to be commensurate with the high yields that international investors would be demanding. So if we don't get on to a stable path, some inflation and higher interest rates would probably be the ultimate outcome no matter what the Fed does. So it's getting to be kind of hackneyed to say, but it is important that we keep this in mind. The trouble is, of course, that Congress is always looking at the next fiscal year, and it's never been very successful at making ten-year budgetary plans.

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