The Fed, Regulation, and MMT - Irresponsible

You've got to hand it to the Federal Reserve. With the cleverness of a seasoned head coach – think Jim Boeheim leading Syracuse in the NCAA basketball tournament – they figured out how to accomplish a great deal while making it look like they didn't have many tools at their disposal.

The market keeps expecting the Fed to bow to pressures to lift rates, and the Fed knows that it can't keep interest rates at zero forever. But it wants to keep them there for as long as it can. So, how do they do that? Well, one way is to forecast higher inflation and real GDP growth so that if (and when) it occurs, you can say "well, that doesn't surprise us at all."

Follow the bouncing ball. At its last meeting, the Fed raised its 2021 real GDP forecast to 6.5% growth, while it expects 2.4% inflation (and argues that it wants inflation to rise above 2%), and unemployment is forecast to fall below 4% in 2022. Despite that outlook, most Fed members are still projecting no increases in short-term interest rates until 2024 or beyond.

As a result, the economy can accelerate to its fastest growth rate since the early 1980s and inflation can move above the Fed's 2% target, all while the Fed sits back and yawns.

Of course, the bond market has a say in things, too. Rapid growth and higher inflation could push up long-term interest rates even further, and at that point the "bond vigilantes" may force the Fed's hand. But the Fed feels confident that it has the tools to deal with this...specifically, asset purchases.

Right now, the Fed is buying $80 billion of Treasury debt each month and $40 billion of mortgage-backed securities. The Fed could raise the total every month, it could shift purchases to longer-dated Treasury debt, or it could buy fewer mortgages and more Treasuries. After all, the housing market is booming, so the Fed can withdraw support.

We think, in the end, the Fed will change its mix of bond buying and be pressured to lift rates before it now expects. Either way, the change in its forecast has bought some time before it does either. And that's good, because the Fed is now wrestling with an entirely different issue. In order for the Fed to operate within an economic policy that certainly looks like Modern Monetary Theory, it must purchase trillions of dollars of government debt.