dahn1_Mark WilsonGetty Images_USfederalreserve Mark Wilson/Getty Images

The US Federal Reserve’s Debt Purchases Are a Warning

As was true during World War II, the US Federal Reserve needs to buy Treasury debt on a sustained basis to prevent crippling interest-rate spikes. This “new normal” is a clear warning that the US must address new generation-spanning challenges such as excessive government debt with a wartime sense of urgency.

ALEXANDRIA, VIRGINIA – In a 2017 speech, John Williams, then the president of the Federal Reserve Bank of San Francisco, warned that, “post-financial crisis, things are returning to normal. But normal may look and feel quite a bit different from what you’re used to.” More recently, Williams, now in charge of the New York Fed, pointed to retiring baby boomers, falling fertility rates, and declining productivity growth as reasons for falling trend growth in the United States.

Weak labor-force and productivity growth are textbook causes of economic slowdowns. But in the case of the US, we also must consider the well-known negative effects of debt. In his recent book Fiscal Therapy, William Gale, one of the founders of the Urban-Brookings Tax Policy Center, points to numerous studies showing that “higher debt levels reduce economic growth by economically significant amounts.” And the seriousness of the US debt problem is evident in the increasing frequency with which the US Federal Reserve has had to intervene in government-debt markets with quantitative-easing, repo, and bill-buying operations to prevent huge congressionally enacted deficits from driving up interest rates and crippling the economy.

Likewise, in his book Principles for Navigating Big Debt Crises, the prominent hedge-fund manager Ray Dalio describes what central banks have historically done when government debt issuance exceeds the market’s appetite. He argues that the Fed today is in a situation similar to that of the early 1940s, when it had to finance the government deficits needed to win World War II. The war deficit, like current US fiscal policy, was a political decision. To help America win the war, the Fed had to give up its independence. It set the overnight rate at zero and the ten-year Treasury-bond rate at 2%, and bought whatever debt the Treasury needed to issue to finance the war effort. Dalio refers to such measures as Monetary Policy 3, or MP3.

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