By Steven K. Beckner

(MNI) – Although the Federal Reserve’s main province is monetary
policy, fiscal policy impinges on that realm, and it known to be
watching Washington’s fiscal fiasco with growing consternation.

For quite some time, the Federal Reserve has been balefully
watching ever larger deficit spending expand the national debt, not just
in absolute terms but as a percent of GDP.

Now, the fat is in the fire — or getting perilously close to the
fire — in wake of Standard & Poor’s action lowering its outlook for
U.S. debt from “stable” to “negative” and warning there is “at least a
one-in-three” chance of an actual ratings downgrade within two years.

Treasury Secretary Timothy Geithner has been scrambling to give
reassurances to investors worldwide that there is no real risk that the
federal government will lose its triple-A rating. He confidently
predicted Tuesday that President Obama will reach a deal to cut the
budget deficit and raise the national debt ceiling.

Perhaps, Geithner will prove correct. But the reality is that, up
until now, House Republicans, the Democrat-controlled Senate and the
White House remain very far apart on dealing with the long-term fiscal
situation — leaving the Fed and the rest of us on tenterhooks.

The recently passed and much-ballyhooed $38.5 billion package of
“spending cuts,” which had been whittled down from a proposed $61
billion, proved to be only $352 million, by the Congressional Budget
Office’s reckoning. This kind of political timidity does little to
reassure the Fed or the bond market.

The International Monetary Fund, in its World Economic Outlook
report last week, projected that the U.S. debt-to-GDP ratio, which has
risen from around 40% to more than 60% in the last few years, will climb
to 110% by 2016.

“There is little risk of a large, broad-based increase in
government bond rates in the short term, but there is a chance of sudden
changes, especially in risk premiums, that could threaten global
financial stability,” the IMF warned.

“As (economic) activity continues to pick up, large sovereign
funding requirements will put upward pressure on interest rates, slowing
the recovery of the private sector and lowering potential output,” the
WEO went on. “This could cause abrupt increases in interest rates in the
United States (from especially low levels) that could destabilize global
bond markets, with particularly deleterious effects on emerging market
economies.”

After the S&P announcement, bond yields did in fact leap
following a recent rally that had lowered them. The yield spike later
subsided, but it nonetheless gave a foretaste of things to come if
deficit spending and the piling up of debt are not brought under
control.

From the Fed’s perspective, the rapidly growing national debt is
not just a fiscal policy problem of unprecedented proportions. It is a
potential nightmare for monetary policy.

The longer it goes on without serious spending cuts, the more
difficult will become the Fed’s position. It will become increasingly
difficult to make sensible monetary policy decisions independent of
political, budgetary pressures.

Already, there are those who question whether monetary and fiscal
policy are properly separated. There is a widespread perception that
quantitative easing — the Fed’s ongoing purchase of $600
billion in longer term Treasuries on top of the $1.7 trillion of assets
previously bought — is aimed, at least in part, at holding down the
cost of financing the national debt.

In his March 1 appearance before the Senate Banking Committee, Fed
Chairman Ben Bernanke was asked whether, in effect, the Fed was using
quantitative easing to support the U.S. Treasury’s financing of the
deficit by holding interest rates down.

Bernanke replied “that’s not our motivation” and said the Fed is
not seeking to “monetize the debt,” but he did not deny that the effect
of Q.E. is to keep Treasury borrowing costs lower than they
would otherwise be.

Although the Fed is not buying new securities outright from the
Treasury, there is no denying that its purchases in the secondary market
have the effect of giving the Treasury a big assist in its debt
management.

Dallas Federal Reserve Bank Richard Fisher, speaking four days
after the FOMC launched QE2 last Nov. 4, warned, “One cost is the risk
of being perceived as embarking on the slippery slope of debt
monetization. We know that once a central bank is perceived as targeting
government debt yields at a time of persistent budget deficits, concern
about debt monetization quickly arises.”

Fisher acknowledged that the Bank of England had also been engaging
in quantitative easing, but observed that the BOE “is offsetting an
announced fiscal policy tightening that out-Thatchers Thatcher. This is
not the case here. Here we suffer from fiscal incontinence and
regulatory misfeasance.”

Though there is little inclination to do so now, there will
eventually come a time when monetary policy needs to be tightened. The
“extended period” of near zero short-term rates and a $2 trillion-plus
balance sheet cannot go on indefinitely. Sentiment for a “normalization”
of monetary policy is growing.

The trouble is that huge budget deficits will make monetary
tightening more difficult.

Fed policymakers cannot help but think, as they raise short-term
rates and/or stop putting downward pressure on long-term rates through
Treasury bond buying, that they will be driving up the cost of funding
the national debt.

And since interest on the debt has become such a huge annual budget
item, Fed officials will have to contemplate that raising rates will
make it that much more difficult to shrink the budget deficit.

After all, interest on the debt would be even larger if not for the
Fed’s low interest rate policies. Interest payments to holders of
Treasury debt, many of them foreigners, are projected to cost $242
billion in fiscal 2012 and $928 billion in 10 years, even at current low
rates. As rates move higher, obviously interest payments will rise even
even faster and absorb a growing proportion of tax revenues. Interest on
the debt will itself become a driver of debt enlargement.

Fed policymakers insist they will do what they have to do to
fulfill their dual mandate. Still the fiscal impact of their actions is
bound to weigh on their minds as they contemplate raising rates.

Refraining from tightening and running a perpetually accommodative
monetary policy isn’t really a sustainable option either, though.
Eventually any effort to hold rates down artificially would drive up
inflation expectations and in turn bond yields. Already, we are seeing
an increase in inflation expectations and inflation itself.

The longer the Fed delays tightening in the face of rising
inflation and inflation expectations, the higher yields are likely to
go. So the Fed will be damned if it does and damned if it doesn’t
tighten.

The sheer size of federal borrowing — in competition with private
demand for capital in a growing economy — will also tend to push rates
higher.

Neither the Fed nor the Treasury have the luxury of operating
solely in the domestic capital markets either. Foreign investors and
governments hold 44% of the national debt of roughly $14.3 trillion, and
they will not indefinitely swallow a growing volume of U.S. debt at
prevailing exchange rates and interest rates.

If the mounting federal debt and the perception that American
politicians lack the will to adequately address it threaten to undermine
confidence in the dollar, whose reserve currency and “safe haven” status
have thus far enabled the U.S. to finance its deficits with relative
ease, then America’s fiscal/monetary dilemma will become even more
complicated.

As Bernanke himself has warned on a number of occasions, the rest
of the world won’t give the U.S. government a free ride forever.
Already, there is talk in a number of quarters — Brazil, China, France,
the Arab world — about replacing the dollar.

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