Every time I see references in academic papers to “fiscal dominance,” I envision a gigantic dominatrix, whip in hand, staring down at the world.
And that isn’t far from the truth. The term, which found renewed application after the 2008 financial crisis, refers to the domination of fiscal policy over monetary policy. It describes the extent to which budget deficits determine central bank actions. Once subjugated, the central bank’s role is to monetize the debt to keep interest rates low and inflate away the debt burden.
It’s hardly the role central bankers envisioned for themselves. After spending the last three decades delivering on their pledge of stable prices, the last thing they want to do is sacrifice their credibility, which has costs. Yet some economists think we may be getting near that point.
If interest rates rise and the Federal Reserve, in the normal conduct of monetary policy, has to sell securities from its huge portfolio, it could incur a loss. Too many losses mean less or no money to turn over to the Treasury Department. (The Fed earns interest on its securities and remits the balance, after paying operating expenses and interest on reserves, to the Treasury; in essence, to the taxpayer.)
Last year, the Fed remitted a record $88.4 billion to the Treasury after a $75.4 billion payment in 2011. Financing the U.S. government isn’t part of the Fed’s job description. Why should it be an issue if those remittances dwindle?
Because a bookkeeping issue will quickly turn into a political issue, according to Al Broaddus, former president of the Richmond Fed. Some lawmakers will forget about all the years of generous remittances and use a one-year loss as an excuse to curtail the Fed’s independence.
“At the end of the day, it looks like quantitative easing was the right thing to do,” Broaddus said. Would politicians have wanted the Fed to roll the dice and do nothing to avoid a potential bookkeeping loss? Probably not, he said.
As a point of reference, the Fed earned $41.5 billion in interest on its securities portfolio in the six months ended in June and paid $2.3 billion in interest on excess reserves.
Bernanke’s announcement in June that the Fed would refrain from selling its holdings of mortgage-backed securities reduced some of the concern about portfolio losses and prompted some staff economists to revise their projections of Fed earnings. They now expect annual remittances to the Treasury “to remain elevated by historical standards through 2015,” declining to a low of $17 billion in 2018, close to the $25 billion average in the decade before the financial crisis. Cumulative remittances from 2009 through 2025 should exceed $900 billion.
In January, the economists had projected unprecedented losses and no profits for the Treasury for up to six years.
The Fed could have mitigated balance-sheet losses by sticking to its traditional operating procedure of buying short-term securities: expanding the balance sheet without increasing interest-rate risk. But as Bernanke explained in December 2008, the focus of monetary policy was shifting to the asset side of the balance sheet, not the liability side. P, the price of long-term bonds, became more important than Q, the quantity of money created though purchases.
The potential bookkeeping loss is actually a small part of the story. The bigger issue is one that was described in a February 2012 paper (revised in July) by economists David Greenlaw, James D. Hamilton, Peter Hooper and Frederic S. Mishkin: “Crunch Time: Fiscal Crises and the Role of Monetary Policy.”
“Fiscal dominance forces the central bank to pursue inflationary monetary policy even if it has a strong commitment to control inflation,” the economists said. “Ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”
I asked Hamilton to outline a scenario under which monetary policy would be subjugated to fiscal policy. Here’s what he said. Congress fails to take actions to address the U.S.’s long-term fiscal imbalances. Confidence in Washington fades. The Treasury holds a bond auction that is undersubscribed, leading to a spike in interest rates.
“What would the Fed do under the circumstances?” Hamilton said. “They’d pretty much have to step in, assure dealers they would buy the debt.”
What might seem like a short-term solution could turn into something protracted if investors bail. “It’s not a way to solve things, but we could find ourselves in that situation,” he said.
Central bankers, weaned on the idea of low inflation as the Holy Grail, aren’t really going to play that game, are they? The answer I got surprised me.
There are two schools of thought on the issue, explained Marvin Goodfriend, a professor of economics at Carnegie Mellon University in Pittsburgh and former research director at the Richmond Fed. The first holds that “central bank independence is illusive” and only as good as the public’s belief in the central bank’s commitment to stable prices.
The other view? “The central bank is available when needed if a country becomes paralyzed,” Goodfriend said.
OK, but real central bankers don’t ascribe to that view, do they?
“Having studied the issue for a lifetime, I can tell you the second view is taken seriously,” Goodfriend said.
I’m already sorry I asked.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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