Because of the large fiscal deficits and rising federal debt, a narrative has emerged that the Federal Reserve will succumb to pressures (1) to keep interest rates low to help service the debt and (2) to maintain asset purchases to help finance the federal government. My goal today is to definitively put that narrative to rest. It is simply wrong. Monetary policy has not and will not be conducted for these purposes. My colleagues and I will continue to act solely to fulfill our congressionally mandated goals of maximum employment and price stability. The Federal Open Market Committee (FOMC) determines the appropriate monetary policy actions solely to move the economy towards those goals. Deficit financing and debt servicing issues play no role in our policy decisions and never will.Interestingly, Waller goes back to the previous time when federal debt relative to GDP was hitting all-time highs--just after World War II. he analogy to the large rise in government debt during World War II interests me. In 1941, federal debt held by the public was 41.5% of GDP; by 1946, it had leaped to 106.1% of GDP. The Fed was essentially willing to hand off interest rate policy to the US Treasury during World War II: to put it another way, the Fed was fine with low interest rates as a way of helping to raise funds to win the war. But a few years after World War II, even though the US Treasury would have preferred an ongoing policy of low interest rates with all the accumulated debt, the Fed took back interest rate policy. Waller said (footnotes omitted):
When governments run up large debts, the interest cost to servicing this debt will be substantial. Money earmarked to make interest payments could be used for other purposes if interest rates were lower. Thus, the fiscal authority has a strong incentive to keep interest rates low.
Thus, the ratio of federal debt/GDP rose by 65 percentage points in the five years from 1941-1946. It has now risen (at least) 57 percentage points over the 14 years from 2007-2021. In rough terms, it's fair to say that federal borrowing for the Great Recession and the pandemic has been quite similar (relative to the size of the US economy) to federal borrowing to fight World War II. Of course, a major difference is that federal spending dropped precipitously after World War II, while the current projections for federal spending suggest an ongoing rise.
The United States faced this situation during World War II. Marriner Eccles, who chaired the Federal Reserve at the time, favored financing the war by coupling tax increases with wage and price controls. But, ultimately, he and his colleagues on the FOMC [Federal Open Market Committee] concluded that winning the war was the most important goal, and that providing the government with cheap financing was the most effective way for the Federal Reserve to support that goal. So the U.S. government ran up a substantial amount of debt to fund the war effort in a low interest rate environment, allowing the Treasury to have low debt servicing costs. This approach freed up resources for the war effort and was the right course of action during a crisis as extreme as a major world war.For comparison, starting in 2007 before the Great Recession, the ratio of federal debt/GDP was 35.2% of GDP. By the end of the Great Recession, federal debt had doubled to 70.3% of GDP. The most recent Congressional Budget Office projections in February, forecast that federal debt will be 92.7% of GDP this year. This should be considered a lower-end estimate, because these estimates were done before the passage of the American Rescue Plan Act signed into law on March 11, 2021,
After the war was over and victory was achieved, the Treasury still had a large stock of debt to manage and still had control over interest rates. The postwar boom in consumption, along with excessively low interest rates, led to a burst of inflation. Without control over interest rates, the Federal Reserve could not enact the appropriate interest rate policies to rein in inflation. As a result, prices increased 41.8 percent from January 1946 to March 1951, or an average of 6.3 percent year over year. This trend, and efforts by then-Chair Thomas McCabe and then-Board member Eccles, ultimately led to the Treasury-Fed Accord of 1951, which restored interest rate policy to the Federal Reserve. The purpose of the accord was to ensure that interest rate policy would be implemented to ensure the proper functioning of the economy, not to make debt financing cheap for the U.S. government.
Thus, the ratio of federal debt/GDP rose by 65 percentage points in the five years from 1941-1946. It has now risen (at least) 57 percentage points over the 14 years from 2007-2021. In rough terms, it's fair to say that federal borrowing for the Great Recession and the pandemic has been quite similar (relative to the size of the US economy) to federal borrowing to fight World War II. Of course, a major difference is that federal spending dropped precipitously after World War II, while the current projections for federal spending suggest an ongoing rise.
In extreme situations, including World War II, the Great Recession, and the pandemic recession, the Fed and the rest of the US government has focused on addressing the immediate need. But by definition, emergencies can't last forever, Given the current trajectories of spending and taxes, we are on a path where at some point in the medium term, a confrontation between the enormous borrowing of the US Treasury and the Fed control over interest rates seems plausible.
For more on the Fed-Treasury Accord of 1951, when the Fed took back control over interest rates, useful starting points include:
- This short overview at the Federal Reserve's "history" website.
- The articles in this special issue of the Economic Quarterly published by the Federal Reserve Bank of Richmond in 2001, on the 50th anniversary of the Accord.