Interest Rates, Federal Deficits, and Inflationary Potential

June 15, 2009

If a credible plan to  reduce significantly the ongoing Federal deficits is not put in place, we face the risk of escalating inflationary expectations and a real fight between the Fed and the administration and congress. That would be a terrible development. It could seriously jeopardize the Fed’s independence. Note that never in economic history has hyperinflation occurred in a country that had a truly independent central bank.


In recent weeks we have seen a somewhat unexpected and significant rise in yields of U.S. Treasury bonds.  The ten-year maturity has climbed persistently since early March, and is now just under 4%.  The low was reached in early January at 2.038%.  The yield on the two-year Treasury bottomed in December at 0.65%, and has now risen to 1.33%.

Two year vs.ten year treasury

Much of the commentary I see and read about this blames investor expectations of large demands for future Treasury financing. In March, the Congressional Budget Office projected a deficit, using the president’s budget, of $1.85 trillion, or 13.1% of GDP. To be sure, that’s a factor in causing rates to rise, but not the primary one.

The primary cause, in my opinion, is a welcome increase in investor confidence that is finally directing funds toward riskier securities. Stated another way, fears of a financial Armageddon, which gave rise to a massive flight to safety, have subsided. In fact,   although mortgage rates have been pushed higher, the yield spreads between Treasuries and corporate bonds have actually narrowed. That’s all to the good.

We also must note that despite the rise in Treasury yields, they are still at extremely low levels are not a serious threat to economic recovery.

But, lurking in the background and prepared to pounce on the markets at the least excuse is the threat of inflation, arising from both a set of profligate fiscal conditions and a fear that the Fed will be unable or politically unwilling to withdraw record monetary stimulus on a timely basis.

Over the 59 years spanning my career I have often listened to others expressing serious concern about Federal deficits, government financing “crowding out” private demand for capital, and general fears about government spending and deficits creating chronic inflation.

I have always been relatively dismissive of these concerns, believing first and foremost in the effectiveness of our independent central bank, particularly in containing inflation. Only once have I been disappointed and wrong. That was in the 1970’s when Arthur Burns, then Chairman of the Fed, decided not to risk counteracting the OPEC cartel’s push to raise oil prices, and monetarily validated the cost-push inflationary conditions that existed at that time.

Today, however, I am concerned, very concerned, about the ultimate inflationary result of a potent combination of monetary expansion and lack of a credible plan to bring huge Federal deficits under control. I am not worried about the short term, because for now, both fiscal stimulation and monetary expansion seem fully warranted.

So, I find myself to be a member of a growing group of economists and investors who might be labeled the “third year worry warts”.  We see no inflationary pressures for at least three years during which aggregate demand seems assured of being uncomfortably below both our labor capacity and physical capacity to produce.

The problem with these three-year worries is that they may not remain just inflationary worries. They could rapidly morph into inflation expectations, and expectations shape economic behavior. Rising inflationary expectations discourage lending and encourage borrowing, encourage spending and discourage saving, and rising inflationary expectations tend to increase interest rates and disrupt financial and currency markets.  Left alone, rising inflationary expectations can be self-fulfilling.

I have no doubts that the Fed has the tools necessary to reverse policy when the time comes to do so.  I have no doubt that they will see the need to tighten at an appropriate time. However, it is possible, even likely, that the Fed may find itself wanting to tighten, but because unemployment is likely to stay uncomfortably high well into a recovery, and because the Treasury’s financing needs will remain huge, it will be politically difficult to do so.  I can see it now: irate congressmen tongue lashing the Fed’s chairman for raising the cost of carrying the national debt and being unsympathetic to the jobless millions.  The Fed, always sensitive to threats to its independence, might have to back off. In my judgment, that possibility is the single biggest inflationary threat. The best defense against this would be the bond market itself.  Investors, seeing the inflationary implications of what was happening, would undoubtedly withhold supply of funds from the marketplace and push interest rates up considerably. Economic recovery would be threatened and financial markets badly harmed.

There are some who quite rationally fear that the sheer size of the needed Treasury financing, along with some unwillingness of our trading partners to continue building their dollar holdings, will force the Fed to monetize, i.e., buy for its own account, part of the increase in Federal debt. These fears were irrationally exacerbated by the Fed’s recent purchase of longer maturity Treasuries. It should be noted that despite the label of “quantitative easing” that was attached to that action, it makes no difference to the quantitative change in the monetary base whether the Fed buys long bonds or Treasury bills.  Anything the Fed buys, even furniture for its offices, increases the monetary base. It can, however, make a difference to the shape of the yield curve, and that’s what the Fed was trying to accomplish.

Bringing the deficits under control will be extremely difficult.  In the short term it simply will not happen because of the need for fiscal stimulus.  Longer term we face not only the usual political headwinds, but also the gigantic increases that will occur in the costs of Medicare and whatever additional healthcare programs might be legislated, and increasing Social Security payouts that will occur with the retirements of the baby boomers. (the oldest of whom are 64 this year)

According to my economist/econometrician/friend, Larry Chimerine, the Bush tax cuts, even after adjusting for the added tax revenues from additional economic growth they created, have created a structural imbalance of $200 billion plus per year, without even accounting for the increased interest costs. The Medicare drug program was enacted without any dedicated revenue source.  It’s costing $100 billion per year. And we’re spending $165 billion a year on two wars on top of an ongoing increase in defense spending where primarily older weapons systems and military aircraft are being replaced by newer, more modern equipment and aircraft.  Just these three together, the Bush tax cuts, the Medicare drug program, and increased defense spending have widened the budget deficit, every year going forward, by over $500 billion.

Additionally, coincident with the economic contraction that has reduced tax revenues dramatically, we’ve enacted the stimulus package, and the bailout packages, which when added together total a staggering $1.7 trillion.

Ten years from now, the number of Medicare recipients will be 30% higher than it is today, while the overall population will grow just 13%. The number of Social Security recipients will grow by about 25%.  Even without the recession and the stimulus programs we would be looking at budget deficits, on an annual basis going forward, of something like $800 or $900 billion per year.

President Obama has spoken forcefully in favor of deficit reduction. But we need much more than words. The administration’s budgetary projections of declining deficits (down to 4.2% of GDP by 2012) are based on clearly overly optimistic assumptions on economic growth. The numbers are simply not credible.

Currently, the president has the strong level of popularity necessary to play a forceful role in formulating a credible plan for deficit reduction. Let’s hope he doesn’t squander it. In particular, we need Congress to show some backbone.  It’s very difficult to trust that it will do so.

The next three years present a very narrow and treacherous pathway.  On one side are the necessary but politically difficult decisions to reduce entitlements and increase tax revenues to reduce future deficits, and on the other side is a potential inflationary chasm.


The Passing of a Great Mind

June 15, 2009

It was with great sadness that I read of Peter L. Bernsein’s death on June 5, 2009. I have known Peter since the 1960’s and 1970’s when he and I appeared together on several programs/panels sponsored by The Conference Board, Annual Analysts’ Societies conventions or the glitzy conferences put on by Institutional Investor magazine.

I have read almost all of his books, and have been a subscriber to his biweekly letter since it was first published. Occasionally I would talk to Peter by phone when I disagreed with him. He usually convinced me that he was right.

There is nobody in the profession whom I have quoted more. He was smart, incisive, provacative, and a really nice guy. I will miss him.