Judd Gregg: The Fed Leaps into the Unknown

Judd Gregg, a former Republican senator from New Hampshire, served as chairman of the Senate Budget Committee from 2005 to 2007 and ranking member from 2007 to 2011. He recently wrote an op-ed featured in The Hill. It is reposted here.

The Trump administration does not seem to consider the deficit or the federal debt to be much of a concern.

In May, it sent up a budget that was so filled with mystical numbers that it would not have passed the smell test for financing a casino in Atlantic City.

It has said with great bravado that entitlement programs such as Medicare and Social Security — the engines that are driving the federal fiscal cars toward the cliff of unsustainable debt — cannot be tuned in any way.

This position guarantees that deficits will climb back to $1 trillion per year early in the next decade.

More uncertainty is now headed our way in relation to the nation’s finances.

The Federal Reserve is beginning the business of right-sizing its own balance sheet. 

In response to the banking crisis of 2008, the Fed increased its balance sheet from approximately $900 billion to $4.5 trillion by a simple means: It printed a lot of money.

It did this primarily by buying two types of assets, U.S. treasury bonds and mortgage-backed securities. It now owns approximately $2.5 trillion of U.S. bonds and $1.8 trillion of mortgage-backed securities.

The Fed has announced that it intends to start reducing this ownership and thus shrinking its balance sheet.

This is a move that has been long expected. For many Republicans in Congress and in this administration, it is overdue.

Throughout the Obama administration, many Republicans called for the Fed to reduce its balance sheet.

There was a general feeling that the Obama administration was abetted in its massive expansion in government spending — and concomitant debt — by the low interest rates and bond-buying policies of the Fed. 

This was true. 

But the Fed’s actions also avoided an even more devastating recession then the one that occurred in 2008 and 2009. Its strategies for avoiding such a disaster were probably only tangentially affected by a desire to help the Congress and president cover their profligate spending policies.

However, now the music of easy monetary policy is modulating.

Does anyone know what we are going to get when the Fed begins the downsizing of its balance sheet in earnest?

The answer is no.

No economy has ever been through this. It is a massive unknown.

At the same time that the Fed is reducing its balance sheet by not renewing its ownership of bonds as they come due over the next two years, it is also embarking on a process of raising interest rates back to more normal levels.  

How these two actions will interact is really a guess, regardless of how many sophisticated, predictive economic models might suggest they have an answer.

The variables are massive. Some, one suspects, cannot be anticipated due to the global nature of markets as well as the vagaries created by human avarice.

But a couple of things will occur that are going to hit this administration and Congress on the side of the head, hard. 

Interest rates will go up. They may well go up a great deal higher and faster than the models predict.

If the Fed raises rates and reduces its bond ownership simultaneously, the likely effect is a whirlwind that will power further interest rate increases.  

The fallout from this is not entirely clear. But one obvious effect will be that the cost of financing the federal debt will jump. 

It costs approximately $400 billion more over ten years for every one quarter of one percentage point rise in interest. If interest rates increase by one percentage point, which is a low-ball number, the de facto federal debt jumps by $1.6 trillion — and this is compounded by the fact that those increased debts will be paid for by more borrowing.  

This makes the debt projections of the administration and the Congress grossly understated, even using their specious rosy assumptions and budget gimmicks.

But that could only be the beginning.

It is distinctly possible, depending on how world markets view the Fed’s actions, that this could be the tipping over of the first domino in a sequence which leads to a loss of confidence in the federal government’s ability to pay back its massively accelerating debt burden.  

How that loss of confidence evolves is obviously dangerous ground.  

If the Congress and president had a credible plan in place to slow this exploding deficit and debt such a loss of confidence might be avoided. 

But this president and this Congress appear to be incapable of developing such a plan, even though it is the gravamen of conservative governance. 

And thus how this plays out is unpredictable.

We are headed into the unconsidered unknown. That is rarely good for a nation or its people.

"My Views" are works published by members or staff of the Committee for a Responsible Federal Budget, but they do not necessarily reflect the views of all members of the committee.