"Now is not the time to worry about debt, but use the great fiscal power of the U.S. to avoid deeper damage to the economy."
The statement by Federal Reserve Chairman Jerome Powell on April 29 marked the completion of an extraordinary reversal in the relationship between the Federal Reserve and the U.S. government.
In December 2018, Powell appeared a paragon of central bank independence as he clashed with President Donald Trump and pushed up the federal funds rate to 2.25%-2.5% to keep a lid on what it perceived to be an overheating economy.
Now, the goals of the Federal Reserve and the U.S. government are much more closely aligned. Treasury needs to issue unprecedented amounts of debt to support $3 trillion of government spending commitments to rescue the economy from its coronavirus-induced slump, while the Fed has announced an open-ended program of government bond purchases.
The harmony between fiscal and monetary policy was also strikingly clear in the U.K. on March 11, when an extraordinary rate cut by the Bank of England was followed mere hours later by a major fiscal stimulus by the U.K. government. A week later the BoE resumed its quantitative easing program.
While few would argue against a period of extraordinary monetary policy to prevent the pandemic morphing into an economic depression, it sets up a major test of central bank independence further down the line when policy makers will have to weigh their mandate to keep inflation in check with the fiscal repercussions of higher government borrowing costs.
"We think it will be very hard for central banks to deny this form of help [asset purchases] even if inflation rises over the medium and longer term," Joachim Fels, global economic advisor for PIMCO, wrote in a report.
The "help" central banks have been providing to their respective Treasurys already has been extensive.
The total assets held by the four big developed country balance sheets — the Fed, European Central Bank, Bank of Japan and Bank of England — totaled about $19.1 trillion as of May 6, up from less than $15.3 trillion in late February as all four restarted quantitative easing programs.
Assets held on the Federal Reserve's balance sheet have climbed from $4.159 trillion on Feb. 26 to $6.934 trillion on May 13 as it ramped up purchases of Treasurys and mortgage-backed securities, and could reach as high as $10 trillion, according to Thomas Costerg, senior U.S. economist at Pictet Wealth Management.
At around 45% of U.S. GDP this would still be a long way from the Bank of Japan where the balance sheet stands at around 125% of GDP.
Central bank purchases are still unlikely to keep up with new government bond issuance this year.
Still, the result is central banks are rapidly assuming an ever greater share of their governments' debt.
The Fed owned 36% of U.S. Treasury securities as of the end of 2019 according to the March Treasury Bulletin and that figure is only set to climb this year. The Fed will purchase $2.52 trillion of Treasurys this year, or 61% of net issuance, according to Goldman Sachs. The Bank of Japan is predicted to buy 52% of net issuance this year, while in the U.K. that figure is almost 87%, Goldman said in a report.
But while it is clear that for many governments their debt would not be sustainable without quantitative easing, most economists argue that this, for now, does not equate to monetary financing.
Quantitative easing is the process whereby central banks create reserves with which to buy financial assets.
"Reserves are not money because they're interest bearing so that's why it's not monetisation," said David Miles, a member of the Monetary Policy Committee of the Bank of England between 2009 and 2015 who helped introduce QE in the U.K. in November 2009.
"If the government tells banks to keep rates low then it's more like monetization, because then reserves become a bit more like notes," Miles said in an interview.
A distinction is drawn between quantitative easing and "helicopter money," which would involve money being printed and distributed by the government to people.
"At the end of the day the intention [for QE] is always there to sell it back into the market and reverse it," said David Owen, chief European economist at Jefferies, in an interview. "That's one huge difference. Helicopter money is giving everybody cash but you can't reverse it."
The principal task of central banks is to target inflation, typically at around 2%. When inflation rises above that level, independent central banks are expected to raise rates, lowering the money supply and encouraging saving. But with government debt spiking, any rate hikes will increase the cost of the debt burden.
"You can imagine there will come a point, not in the near term but perhaps in a few years, where there's some inflationary pressure. It's going to be hard to move up rates due to the very high leverage built up in the public sector and corporate sector," said Nicola Mai, a portfolio manager and sovereign credit analyst at Pimco.
"There will be some tolerance of higher level inflation," she said in an interview.
For now at least there is little imminent threat of inflation. Measures to limit the spread of the coronavirus have decimated consumer spending as labor markets have collapsed. U.S. unemployment at the end of April was reported by the Bureau of Labor Statistics at a post-war high of 14.7%.
In its World Economic Outlook published in April, the IMF forecast inflation in the U.S. will drop to 0.6% in 2020, from 1.8% in 2019, while the euro area and Japan are expected to see the rate drop to just 0.2%.
Gregory Daco, senior U.S. economist at Oxford Economics suggests inflation in the U.S. could go even lower to 0.5%, but warned, "One important risk for inflation is the 'fiscal dominance' of the Fed whereby debt monetization becomes a permanent feature of monetary policy. While not an immediate threat under Jerome Powell, it could become one in the future."
But Miles expects that if faced with inflation, banks will raise rates and noted that governments have often been able to cope with higher debt burdens, pointing out that even if the U.K. government debt jumps some 30% to 110% of GDP, that would be significantly lower than in World War II or the Napoleonic wars, when debt-to-GDP reached 250% and 200%, respectively.
"One could paint scenarios in which people lose faith in low inflation situation. You could tell a story where 10-year yields go up 500 basis points. Is that impossible? Not it's not. Is it likely? Well the lessons of history are that the U.K. has been able to bring down debt-to-GDP ratio without inflating in the past," Miles said.