By Steven K. Beckner

(MNI) – Federal deficit spending and the mounting debt it produces
have serious implications for monetary policy, including the potential
for inflation and a loss of Federal Reserve independence, Richmond
Federal Reserve Bank President Jeffrey Lacker writes in the Bank’s
annual report released Thursday.

Lacker warns that, if the debt-to-GDP ratio climbs as projected by
the Congressional Budget, the United States could reach its “fiscal
limit,” at which it would be unable to finance budget deficits.

At that point, the nation would face a choice between government
default or inflationary finance, Lacker cautions.

John Weinberg, Richmond Fed senior vice president and director of
research, and staffer Renee Haltom back up Lacker’s contentions in a
much longer essay in the annual report.

“Economic research suggests that high debt levels ultimately could
overwhelm a central bank’s efforts to keep prices stable,” the
two economists write.

The CBO has projected further substantial increases in federal debt
as a percentage of GDP. In its “baseline” scenario, which assumes
current laws will remain constant, tax cuts that are set to expire will
not be extended, and spending will be held in check as promised, the CBO
projects the debt-to-GDP ratio will rise to 84% by 2035 from nearly 68%.

In an “alternative” scenario, which it deems more likely, spending
outpaces revenues more dramatically, and the debt to GDP ratio rises to
109% by 2023 and surpasses 200% by the late 2030s.

“Those projections are alarming, and if they come to pass, they
could pose significant challenges for monetary policy,” Lacker writes.
“If the federal debt were to rise to such levels, it is conceivable that
our country could hit what economists call the ‘fiscal limit,’ where it
would no longer be possible to raise enough money to resolve the fiscal
imbalance.”

“The result would be a very unsatisfying choice: federal debt could
be reduced through default, or the real level of the debt could be
reduced through inflationary actions by the central bank,” he adds.

The Fed’s committment to price stability may have a hard time
withstanding pressure from fiscal authorities to assist debt finance,
Lacker fears.

“Although containing inflation has widespread public support, one
must acknowledge that the federal government might be tempted to seek
the assistance of the central bank in addressing fiscal problems,
especially if those problems become acute,” he writes. “Indeed, there
have been calls in some quarters for the Fed to deliberately engineer
higher inflation to reduce the real debt burden on private borrowers.”

“It’s only a short step from that position to advocating inflation
to reduce the real burden of the federal debt or to minimize the
interest expense on federal obligations,” he adds.

As the debt mounts and becomes more difficult to fund, Lacker warns
that “pressures could emerge that would threaten that independence if
the federal government were on the brink of default.”

“Even more disturbing, inflation still could break loose before the
fiscal limit is reached,” he goes on. “Research suggests that simply
approaching the fiscal limit could be enough to convince markets that
the central bank eventually will act to alleviate fiscal pressures. Such
expectations could raise inflation without any change in central bank
policy.”

Lacker observes that apparently, market participants believe an
agreement will be reached to curb the deficit, since “the public remains
willing to purchase government debt in the form of U.S. Treasury
securities at very low interest rates, and inflation expectations remain
subdued.”

“But policymakers must not be complacent,” he writes. “Those in
charge of fiscal policy must not exploit the public’s continued trust to
delay difficult compromises. And monetary policymakers must be mindful
that a central bank’s credibility, once lost, can be recovered only at a
steep price.”

In their essay, Weinberg and Haltom say “governments can sustain
moderate deficits seemingly indefinitely,” but “the larger the debt
grows, the larger future surpluses — revenues in excess of spending —
must be to satisfy the equation.”

But future surpluses are limited because “spending cannot drop to
zero” and because “tax revenues have an upper limit” due to the
disincentives to work caused by higher tax rates.

At some point, which they do not specify, Weinberg and Haltom
predict, the government will reach its “fiscal limit,” at which “the
government cannot borrow further, and the government’s existing spending
promises therefore cannot be funded.”

At that point, they say, “at least one of two events must occur at
the fiscal limit: the government would reduce its debt levels by
defaulting, or real debt levels would be reduced through actions taken
by the central bank.”

One thing the Fed could do would be to increase “seigniorage” — the
amount of interest it earns and passes on to the Treasury from its
securities holdings — by creating money to buy more Treasury
securities.

Last year, the Fed remitted $75.4 billion to Treasury after paying
it $79.3 billion in 2010 out of earnings on its vastly expanded
portfolio.

The Richmond Fed economists write that buying more securities for
the purpose of paying the Treasury more interest to help finance the
deficit would amount to “‘monetizing’ government debt: if the market
grows unwilling to purchase government debt at low rates, the central
bank can step in to purchase that debt directly from the government.”

The other way the Fed could help reduce the debt burden would be by
“creating inflation that was not anticipated by financial markets,” they
write. “Inflation allows all borrowers, the government included, to
repay loans issued in nominal terms with cheaper dollars than the ones
they borrowed….”

For now, since U.S. inflation “tends to be low and predictable,”
Weinberg and Haltom say that higher inflation produces “only a small
transfer of wealth from lenders to borrowers.” To have a bigger effect
there would have to be “a significant deviation” from expectations.

“Between low, stable inflation and minimal seigniorage revenue, the
Federal Reserve’s policies generally have little direct impact on the
government’s debt burden,” they write. “This could change, however, if
financial markets began to view hitting the fiscal limit as a
possibility.”

“That situation would inevitably invite monetary policymakers to
intervene since inflation presents one possible source of revenue,” they
add.

Even a well-intentioned central bank could be forced into
inflationary policies, Weinberg and Haltom warn.

In one scenario put forth by economists Thomas Sargent and Neil
Wallace, where the government reaches the debt limit but continues to
run budget deficits, “if the government is to avoid default, the central
bank has no choice but to produce inflation to reduce debt levels and
satisfy the intertemporal budget constraint.”

(The government’s intertemporal budget constraint says that the
value of the government’s outstanding debt must equal the present value
of its expected future surpluses).

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