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In this week’s Grumpy Economist Weekly Rant, John Cochrane examines one of the hardest challenges facing the Federal Reserve under Kevin Warsh’s leadership: what happens when fighting inflation collides with America’s fiscal reality. Cochrane argues that raising interest rates is never politically easy, but today’s high debt makes the problem much more difficult.
With debt near 100 percent of GDP, higher interest rates mean higher interest costs for the federal government. Cochrane warns that unless Congress is willing to raise taxes or cut spending to cover those costs, monetary policy alone may not be enough to bring inflation down. The deeper issue, he argues, is the growing pressure on the Fed to support government borrowing in moments of fiscal stress, crisis, or war — a problem that will require clearer thinking about how monetary and fiscal policy should interact.
Transcript
Hi, I’m John Cochrane, senior fellow here at the Hoover Institution, and welcome to my Grumpy Economist Weekly Rant.
This week, I’m going to think some more about the challenges facing the Fed in the wake of our colleague and friend Kevin Warsh’s appointment as Fed chair. This week: the fiscal challenges.
Suppose the time comes that the Fed really does want to raise rates. Inflation is rising out of control. Time to do something about it. This will be very difficult. The usual forces against it will be evident. Raising rates might cause a recession and lots of people to be unemployed. Don’t forget, Fed Chair Volcker, who we now think of as the great inflation-fighting Fed chair, had farmers out in protest, driving tractors around the Federal Reserve. They were very mad about higher interest rates. Home builders, home buyers, people who want to buy cars — nobody likes higher interest rates.
Politicians, both Congress and the president, will be very unhappy, but that’s only the beginning of the Fed’s troubles. If the Fed raises interest rates, all the too-big-to-fail banks will be in danger once again. Remember Silicon Valley Bank’s failure and the near failure of many other banks in the United States, the last time the Fed raised interest rates. The banks lost money on their assets, depositors started to run, and the Fed had to bail everyone out once again.
That’s going to make the Fed’s life difficult, but the worst one is interest costs. With our 100 percent debt-to-GDP ratio, every 1 percent rise in interest rates is 1 percent of GDP more deficit. Congress has to pay that deficit now or in the future by raising taxes or cutting spending. If Congress does not do so, higher interest rates cannot lower inflation. Lowering inflation always needs a joint monetary and fiscal policy.
So imagine Congress when our friend and colleague Kevin Warsh goes in and says, “Guys, gals, I’ve got to raise interest rates. We need a couple percent more GDP of higher taxes or lower spending from you to pay the higher interest costs on the debt.” Congress will be really, really unhappy, and the president unhappier still.
It has to be done. It’s difficult. Fiscal problems only get worse from there. As you know, our country has uncontrolled deficits. We are already seeing long-term interest rates starting to rise, possibly as bond markets get tired of lending and lending and lending with no plan for being paid back.
What happens to countries in that situation? We have plenty of evidence from around the world. As deficits get worse, long-term interest rates go up, and governments pressure central banks hard to hold down those long-term interest rates. The precedent here is after World War II, when, in fact, the government told the Fed, “Hold down long-term interest rates. Buy bonds to do it.”
And with the precedents of quantitative easing and 2020 in the rearview mirror, it’s going to be awfully hard for the Fed to say no. After all, low long-term interest rates are part of the Fed’s legal mandate. And if that causes inflation, well, we’ll blame it on price gougers and speculators once again.
It gets worse still. What happens in the next crisis? Suppose an adverse geopolitical event, to put it mildly, happens. Well, then the government will want to borrow trillions of dollars again. Bond markets will be very skeptical, and the Fed will be called on to buy up trillions of dollars of government debt once again, as it did in World War II.
Do we even want the Fed to resist? Really, we would not have wanted the Fed to refuse to help the government borrow money in World War II. We would not have wanted to lose World War II on the altar of no inflation.
Doing so, the Fed forces the government to tax more, spend less, possibly lose a war, or default on its debt. These are all deep into fiscal and political matters that the Fed should not be interfering in.
How do you handle this? My hope would be that Congress would tell the Fed, “We really want you to fight inflation always and everywhere, and we will pass an exemption as we passed the TARP exemption in the financial crisis, and take the responsibility for financing a war or a crisis.” That kind of thoughtful government is, I hope, in our future, but not there today.
In any case, the fiscal forces on the Fed are going to be much more important in the future than the usual inflation-versus-unemployment forces. It’s a much harder question, and we will only survive the difficult times ahead either if Congress gets its act together and fixes the fiscal problem, or if we think carefully about how the Fed and fiscal policy should interact.
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John H. Cochrane is the Rose-Marie and Jack Anderson Senior Fellow of the Hoover Institution at Stanford University. An economist specializing in financial economics and macroeconomics, he is the author of The Fiscal Theory of the Price Level. He also authors a popular Substack called The Grumpy Economist.