(Bloomberg) — Former Treasury Secretary Lawrence Summers said the Federal Reserve will at some point have to weigh in on the US government’s growing mountain of debt because of its implications for interest rates.
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“I understand that the Fed’s job is not to get involved in fiscal policy, but I think — over time — the Fed is going to have to — as the monetary authority of the country — engage on some of these questions about Treasury debt,” Summers said on Bloomberg Television’s Wall Street Week with David Westin.
“If there’s more debt, much bigger deficits, that means more demand in the economy. And that raises the neutral rate now and raises even more the prospective neutral rate in the future,” Summers said.
Concerns about the US fiscal situation have contributed to a run-up in Treasury bond yields that has surprised policymakers and prompted them to consider holding off on another interest-rate increase. Total US debt outstanding stands at more than $33.5 trillion.
Summers spoke a day after Fed Chair Jerome Powell said that the neutral rate — also known as R star and is the rate at which monetary policy neither stimulates nor restricts the economy — may have risen in the near term, but that it’s very hard to know confidently what it will be in five years.
Fed policymakers, in their September projections, estimated the rate at 2.5%. Summers sees the real neutral rate in a range of 3.5% to 4%.
Debt Effects
“When you’re trying to sell huge amounts of long-term debt because you have very big deficits, its price goes down and that means higher long-term yields, a rising term premium,” said Summers, a Harvard University professor and paid contributor to Bloomberg TV. Term premium refers to the compensation that investors require for bearing the risk that interest rates may change over the life of the bond.
Read More: Wall Street Concerns Over Swelling US Debt Put Fed in Tight Spot
As the neutral rate is being pushed up by wider fiscal gaps, that means the Fed has to “raise the actual rate in order to keep the same degree of balance between the accelerator and the brakes,” said Summers. And as rates and term premia rise, “that’s restraint that’s being applied to the economy.”
That “might substitute for a brake the Fed would otherwise have to provide, so it’s not enough for the Fed to recognize that rates are going up. it has to implicitly be forming a view as to what the cause is,” he said.
Read more: Why US Deficit Is a Worry Again, and Will Remain So: QuickTake
The former Treasury chief hasn’t seen evidence of an illiquid Treasury market, but said that the Fed, particularly its New York branch that’s tasked with monitoring and supporting market function, should focus “even more on assuring good functioning of financial markets, maybe a little bit less on some of the analytical pronouncements about R star. I think that would be helpful in terms of the system performing its function.”
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Source: finance.yahoo.com