Those risks include the scenario in which the size of the debt prompts the central bank to keep rates low to minimise debt servicing costs, rather than contain inflation – a concept known as fiscal dominance.
“The preconditions for fiscal dominance are clearly strengthening,” former treasury secretary and Federal Reserve chair Janet Yellen said Sunday during a panel discussion at the American Economic Association’s annual meeting in Philadelphia.
The Congressional Budget Office has projected the federal deficit this year will be US$1.9 trillion, bringing total debt to about 100% of gross domestic product. That’s seen rising to about 118% of GDP in the next decade.
Yellen also noted that President Donald Trump has “vocally demanded” the Federal Reserve lower interest rates explicitly to reduce the government’s debt-servicing costs.
Yellen has said previously the US was in danger of becoming a “banana republic” if Trump succeeds in forcing the Fed to keep rates low to ease the government’s debt burden.
Speaking on the same panel, Loretta Mester, a former president of the Cleveland Fed, added that the “scariest” component of the current debt problem was that Trump administration officials appeared not to understand the threat involved.
“Previous governments knew they were on a precipice” even if they didn’t act responsibly to tame deficits in the end, she said. “I think this government may not realise the implications.”
Yellen nonetheless said she was hopeful that a crisis – perhaps the looming insolvency of Social Security and Medicare – could spur Congress to strike a bipartisan deal over budget reforms.
“I doubt Americans will end up on the fiscal dominance course, but I definitely think the dangers are real and should be monitored,” she said.
David Romer, an economist at the University of California, Berkeley, said he is “less optimistic” that a bipartisan deal will avert a “fiscal catastrophe.”
“We have a fiscal problem,” Romer said. “If we don’t solve it, that will create problems for everybody, including the Fed.”