With Janet Yellen at Treasury, Joe Biden signals further blurring of fiscal, monetary policies

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In nominating Janet Yellen to become his Treasury secretary, president-elect Joe Biden has opted for a steady hand and consensus-builder to steer U.S. fiscal policy just as economists increasingly warn the country is poised to slip back into recession.

Progressive activists had been pushing for the appointment of Massachusetts Senator and big-government advocate Elizabeth Warren to take the reins at Treasury. Wall Street will be relieved that Mr. Biden picked Ms. Yellen instead, even if she, too, could seek to toughen financial regulations loosened under Republican President Donald Trump.

The highly polarizing Ms. Warren would have faced a challenge winning a confirmation vote in the Senate, which is currently controlled by Republicans and is likely to remain so following two Jan. 5 run-off elections in Georgia. Ms. Yellen’s confirmation is unlikely to be a problem, regardless of which party controls the Senate.

That does not mean her appointment is an entirely uncontroversial one, however. While the 74-year-old labour economist is set to make history as the first woman to hold the top job at Treasury, after serving as the first female chair of the U.S. Federal Reserve between 2014 and 2018, her appointment will serve to further blur the lines between monetary and fiscal policy.

The Fed’s independence from the executive branch and Congress has long been a sacrosanct principle of U.S. government, insulating the central bank from political pressure. However, the current crisis has led to an unprecedented degree of co-ordination between the Fed and the Treasury department, as the central bank moves to facilitate expansionary fiscal policies.

That trend is expected to accelerate under Mr. Biden. The president-elect has already called for the renewal of a Fed lending program that Congress enacted as part of a March stimulus package but that the current Treasury chief Steven Mnuchin last week said would end on Dec. 31. The Fed took the unusual step of publicly disagreeing with Mr. Mnuchin’s move, appearing to some critics to have waded into political matters.

Ms. Yellen would become just the second former Fed chair to serve as Treasury secretary, following the appointment of William Miller in 1979. But his tenure at the Fed lasted barely a year, while his move to Treasury cleared the way for the highly regarded Paul Volcker to take over at the central bank, where he proceeded to wrestle runaway inflation to the ground.

Under current Fed chair Jerome Powell, the central bank has signalled that it will allow the annual inflation rate to surpass its official target of 2 per cent in coming years to make up for long periods of below-target inflation. A similar review of inflation targeting is now under way at the Bank of Canada, which appears to be preparing to follow the Fed in adopting a more flexible approach toward inflation as governments face massive postpandemic debt burdens.

The Fed has ramped up its quantitative easing program since the pandemic struck and the U.S. economy entered a steep recession, from which it only partly recovered. Driven by purchases of Treasury bonds, the Fed’s balance sheet has ballooned to more than US$7-trillion from barely US$4-trillion in February. QE and near-zero interest rates have lit a fire under the stock and real estate markets, buttressing the investment portfolios of the richest Americans, while low-income earners bear the economic brunt of the pandemic.

The Bank of Canada has followed a similar playbook, tripling its holdings of federal government bonds since February to more than $280-billion. It recently announced plans to purchase a minimum of $4-billion in federal debt weekly for the foreseeable future.

Central bank debt purchases – which are funded by the creation of new money – have pumped record amounts of liquidity into the financial system, and enabled governments on both sides of the border to fund historic deficits at record-low interest rates. They have, hence, prevented a much deeper recession by facilitating extraordinary public spending.

The longer-term risks of such monetary measures remain a matter of serious concern. In addition to further inflating asset bubbles and exacerbating economic inequality, they could lead to a loss of credibility as central banks take on roles beyond their traditional mandate to fight inflation.

“The blurring of monetary and fiscal policy means that it is crucial to have proper guardrails around policy co-ordination. In their absence we see a risk that major central banks could lose grip of inflation expectations relative to their target levels,” said a report last week by analysts at the global investment firm BlackRock Inc.

Such a development would unwind decades of hard work by the Fed and the Bank of Canada to put the lid on inflationary pressures that eroded investor confidence in the 1970s and could eventually lead to a return to the double-digit interest rates of the early 1980s.

Few policy makers are likely as acutely aware of such risks as Ms. Yellen, whose credentials arguably make her the most qualified Treasury nominee in modern history. But she is also proof of the increasingly tight relationship between fiscal and monetary officials that some critics fear could lead to a gradual loss of central bank independence.

The Fed’s Mr. Powell has been highly vocal in calling for Congress to adopt another massive stimulus package to prevent the U.S. economy from falling back into recession once many current aid measures expire on Dec. 31. Even if you agree with him, such advocacy risks running afoul of the very “guardrails” BlackRock rightly suggests need to be maintained.

Ms. Yellen’s appointment will only make maintaining them that much harder.

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