MNI INTERVIEW: Chicago Fed Adviser Fears Fiscal Dominance

The Federal Reserve will likely face strong political opposition to raising interest rates in the face of a record budget deficit, raising the risk of future inflation due to central bank inaction or at least a delayed reaction, Chicago Fed Advisor Martin Eichenbaum told MNI.

"When you get to the kind of budget numbers we're talking about, members of Congress are really going to notice," he said in an interview. "We are truly in an unpredictable period and the question is how do they respond if things go wrong on the fiscal front."

There has been rising concern among former and some current Fed staffers that the combination of ultra-loose monetary policy with very proactive fiscal policy under President Joe Biden could spark unwanted inflation beyond the modest overshoot the central bank now seeks under its new framework.

But emerging concerns about "fiscal dominance" are potentially more damaging to the central bank's credibility and institutional independence.

"We get into the situation where the deficit is going nuts, inflation goes up and the Fed has to raise rates by a lot but there's pushback. And if bond markets think that then they might price that in ahead of time" by pushing yields higher, said Eichenbaum, a member of the academic advisory board to the Chicago Fed who is close to its dovish President Charles Evans.

The Fed's framework shift, which also places renewed emphasis on an ever-broader definition of full employment, was announced last August, when the prospect of additional fiscal support for the economy looked dim. The election results changed this in a big way, significantly altering the calculus of potential risks among market participants and some policy makers.

NEW WORLD ORDER

"I anchor this concern in the politics of the situation," said Eichenbaum. "We are used to a world where monetary policy does what it does when debt-to-GDP is 50% or 60%. At 150%, the impact on the budget of having to pay another 50 basis points is substantial. Just think about a homeowner in a similar situation."

The U.S. budget deficit surged to a record USD1.71 trillion in the first half of fiscal 2021, up from USD743 billion for the same period a year earlier.

Eichenbaum is sympathetic to the Fed's attempt to push inflation above its 2% target after a prolonged period of undershooting. But he adds that the Covid recession and the fiscal response have bolstered the outlook for growth and inflation in a way that Fed officials have thus far been reluctant to admit.

"They have very much bought into this whole idea of the Phillips Curve being very flat, so that tells you not to worry about tail events," he said. "Then they tell us if things get out of control we're going to slam on the brakes. There's a question of how you credibly commit to that -- it's not entirely obvious that's how real people understand things."

He said that while the Fed's economists rely on some of the best models, these are inevitably based on data from the fairly recent past. "There's nothing in the last 30 to 40 years that covers the kind of tail risk that some people are concerned about. That's a limitation on what they can do."

The Fed is buying USD120 billion per month of securities and has set interest rates near zero since the start of the pandemic. It has vowed to keep buying bonds until it sees substantial further progress toward price stability and employment goals, and not to raise interest rates until these have been comfortably achieved.

That's a huge shift from the past practice of setting policy based on economic forecasts, Eichenbaum said.

In addition to potentially having to accommodate political actors, the Fed faces pressure from markets that appear priced for perfection and many pockets of what Eichenbaum described as "nuttiness."

"The issue is not monetary policy, I think it's fiscal. I don't think the Fed should raise rates now," he said. "But I do very much worry about a lot of frothiness in the market."

Nonetheless, MNI reported this week the Fed is likely willing to look through bubbles it knows it has helped create in order to meet its targets.