Treasury secretary suggests Biden plans may require rate hikes, spooking investors

U.S. Treasury Secretary Janet Yellen said that the economy could be at risk of overheating if the Biden administration’s spending proposals are approved, raising the prospect that the Federal Reserve could have to raise interest rates to address future inflation.

Her comments, which aired Tuesday and spooked investors, reignited fears raised by some economists and business leaders that trillions of dollars in new spending that the government has authorized since March 2020 could lead the Federal Reserve to take steps that cool off the economy.

The S&P 500 index fell 0.7% and the tech-heavy Nasdaq slipped 1.9% in the wake of her remarks, while the Dow eked out a small gain. The price of oil rose while bond yields slipped slightly.

In an interview with The Atlantic, Yellen defended the Biden administration’s proposed spending programs but said that if approved they may require the central bank to raise interest rates to prevent the economy from expanding too rapidly. The Federal Reserve—not the Treasury Department—sets interest-rate policy, but Yellen has a unique vantage point, having led the Fed at the end of the Obama administration and beginning of the Trump administration. Raising interest rates slows the pace of economic growth by increasing the cost of borrowing.

“It may be that interest rates will have to rise somewhat to make sure our economy does not overheat, even though the additional spending is relatively small relative to the size of the economy,” Yellen said. “It could cause some very modest increases in interest rates to get that reallocation, but these are investments our economy needs to be competitive and to be productive.”

The Biden administration has not suggested that it is rethinking any of its spending plans in the face of inflationary price pressures. And there are a number of factors that appear to be driving prices higher in certain sectors. Some of them have nothing to do with the government’s spending.

For example, the sudden restart of the U.S. economy and continued problems in global supply chains has led to a shortage on a range of items—from computer chips to rental cars—is raising prices sharply.

Yellen’s comments were the most forward-leaning by a senior White House official so far on the issue of inflation, though the administration did not try to instantly distance itself from the treasury secretary.

“We take inflationary risk incredibly seriously,” White House spokeswoman Jen Psaki said.

Yellen’s comments suggest that the Biden administration could look to the Federal Reserve, which Yellen once led, to cool down the economy if their agenda is completely adopted by Congress. President Donald Trump pressured the Fed to lower interest rates to combat economic fallout from his trade agenda.

Inflation in recent months has emerged as a potential concern among leading economists, prompting an extensive White House review. Analysts have also noted the delicate balance the Biden administration is trying to find.

“US policymakers are testing the limits of Goldilocks-they are trying to heat up the economy as fast as possible without generating serious inflation,” economists from Bank of America Global Research wrote in a recent note.

The federal government has pumped trillions of dollars in emergency spending into the U.S. economy since last year, including President Joe Biden’s $1.9 trillion stimulus package, which passed in March. Some analysts fear that this surge in cash will lead consumer demand to overpower supply, raising prices in a way that hurts many Americans.

The Federal Reserve does have ways to address inflation, but there have not been major concerns about it for decades. Fed Chair Jerome Powell has not indicated that near-term government spending increases could suddenly lead to a big inflation concern.

“We’ve been living in a world of strong deflationary pressures—around the world, really—for a quarter of a century, and we don’t think that a one-time surge in spending leading to temporary price increases would disrupt that,” Powell told Congress in March.

If inflation rises rapidly and prices get too high, the Fed could move to raise interest rates to essentially slow the economy. The most extreme recent example of this was in the late 1970s and early 1980s, when the Fed raised its main interest rate benchmark to 20% in an effort to address inflation. High interest rates can also have other affects on the economy, leading to high unemployment and cash-flow problems for businesses.

The first quarter report on economic growth, released by the Bureau of Economic Analysis last week, said that prices grew at a 3.5% annualized rate in the first quarter and are up 1.7% from a year earlier. For now, inflation has primarily spiked only in specific sectors, such as the housing and lumber markets, as suppliers struggle to catch up with a surge in consumer demand. The most commonly measured metric for aggregate inflation has remained in check, at least up to this point.

Biden has proposed more than $4 trillion in additional spending programs that would be infused into the economy over the course of the decade. The White House says those programs are paid for with new taxes. Those taxes could in theory reduce their inflationary impact because the government would be taking out about as much money out of the economy as it is putting in. But the administration has proposed levying those taxes on corporations and high-income Americans, meaning the hikes may do little to slow economic demand because the rich spend a smaller portion of their income than do recipients of the new federal programs.

After contracting sharply last year, the economy appears poised to grow rapidly in 2021. But the economic recovery has been uneven. The stock market is at near-record highs, but millions of Americans remain unemployed, and some parts of the economy are having a hard time snapping back to pre-pandemic levels. Prices on some commodities have risen sharply, raising the threat of inflation, and there is a shortage of computer chips, hampering a range of businesses.

The effects of Yellen’s remarks on markets may be short-lived. Nicole Tanenbaum, partner and chief financial strategist at Chequers Financial Management, said that investors may be overreacting to Yellen’s remarks and that the market should be buoyed by the pace of vaccinations and broader reopening of the U.S. economy.

“Some of these comments exacerbate inflation concerns,” Tanenbaum said. “But some of these fears are overblown, and what investors should focus on is that this is really reflective of a reopening economy and a more robust earnings outlook.”

Others are second-guessing the treasury secretary’s remarks. Marshall Steinbaum, an economist at the University of Utah, said it was “irresponsible” for Yellen to discuss interest-rate hikes when wage growth remained sluggish and millions of Americans remained out of work.

Yellen faced criticism for raising interest rates when she served as chair of the Federal Reserve under the Obama administration, a decision many Fed officials later said was a mistake. Yellen later said the Fed “misjudged” the strength of the labor market.

“It’s way too soon to talk about inflation. Let’s wait until there’s actually evidence of any,” Steinbaum said. “It’s justifiable to talk about when we see wage increases higher than inflation, and we haven’t come close to that.”