Fed must 'keep policy rate restrictive': Economist

Dreyfus and Mellon Chief Economist Vincent Reinhart joins Yahoo Finance Live to analyze the Fed's rate hike strategy ahead of its next meeting, while also discussing the credit rating circumstances tied to the debt ceiling debate.

Video Transcript

JULIE HYMAN: Well, otherwise, we are watching, of course, concerns surrounding the impending x date drawing closer. Investors are looking ahead to the Fed's June meeting as well. Expectations the Central Bank Could hike another quarter point have ticked up in the last couple of weeks. But a pause does seem to be at least the majority consensus right now.

Our next guest cautions that if the Fed does say pause, investors will then expect the red light of stop, as he puts it to shift to the green light of cut. Vincent Reinhart, Dreyfus and Mellon Chief Economist is joining us now. Vince, it's good to see you.

You know. And we have heard some folks bring back to the fore the narrative of, well, maybe it is just a skip rather than a pause. In other words, they could perhaps then raise it further meeting. But the market doesn't seem to have digested that message, does it?

VINCENT REINHART: Well, there is some chatter among policymakers that they're talking about a pause. I think they lack introspection because once you skip a meeting, it becomes much harder to change the policy rate the next meeting. Think back just at the turn of this year, how much trouble they had adjusting the pace of firming.

They cut the pace back a little bit too early. But then they couldn't adjust it because they had set this precedent. They're going to run into the same problem. If they stop, they stop.

JULIE HYMAN: All right, Vince, I've got to ask you about the debt ceiling debate that we have been going through once again. We've been here before, always up on the x date, if you will, it seems. So what should we be concerned about besides this deadline in front of us? Are there any spending payments that would be missed and what are the broader implications?

VINCENT REINHART: OK, there's a couple of things to worry about, actually a lot of things to worry about. Working back from the broader economy, the solution, whatever it will be will involve a slowing in the pace of federal spending. It is going to be therefore leaning into restraint as the economy is slowing. So that's the big macro story.

What you really should worry about, what I worry about is that the x date is actually the far moment when the bad thing happens. Because when you think about it falling off over a cliff is a bad thing, but probably even worse are the moments before you're about to go over the cliff, and you appreciate that your momentum is such that it's inevitable.

That's Janet Yellen's position. The secretary is going to have to queue up some infrastructure instructions about prioritization, about how you'd handle potentially defaulted Treasury securities. So, in fact, we're going to get market moving news before the Treasury actually runs out of cash.

JULIE HYMAN: As we know Fitch is considering a downgrade for US debt. S&P never upgraded it again after they downgraded US debt back in 2011. You know, it seems like when we talk about this a lot of the effects are sort of temporary, right? There's bills that don't get paid in the short term. But then eventually they will raise the thing, whether it's now or later. Are there any lasting economic effects though that we need to think about as a result of all of this?

VINCENT REINHART: Well, I was in Fitch's notice of putting the US on creditwatch. And it's why, as you mentioned, S&P is where it is. The debt ceiling debate is symptomatic of a broader problem. We can't have a grown up conversation about fiscal policy. The US federal debt is large relative to our GDP.

Maybe it can be large because we're such a big country. But it's on a trajectory that seems unsustainable. And something that's unsustainable stops. And does it stop because the markets get tired of continuing to add more and more of debt? That's what Fitch is worried about. That's what S&P is worried about. The debt ceiling is a symptom of a broader problem.

JULIE HYMAN: But, Vince, is it a mistake to couple that what should be a grown up discussion about this with the whole debt ceiling structure at all? Doesn't it make more sense to just divorce the two entirely, you know, have the debt ceiling just be increased? It's stuff that we already committed to. And then have the spending discussion separately.

VINCENT REINHART: Sure. There's lots of things that make more sense. And the basic political economy here is that the Congress is so divided along partisan lines. There's no opportunity to pass legislation. There's no opportunity to have a meaningful discussion, to have a blue ribbon committee to chart out a longer term course. At that point then, politicians have to look for their points of leverage. What's the must-pass legislation?

And unfortunately, every couple of years, a must-pass piece of legislation is the debt ceiling. So this is their opportunity to be in the bright lights. They're taking it. And so is, you know, does much of this make sense? The whole idea of a debt ceiling. The limit on the amount of debt you issued--

- Let me jump in, Vincent. Sorry to interrupt you. But yes, to your point, do we just need to get rid of the debt ceiling, like, should it just go away?

VINCENT REINHART: OK. So people of a certain age like me who worked on the debt ceiling for a long time-- I was the point of contact when I was at the Federal Reserve for 25 years-- all have a shared experience. And that was when Senator Robert Byrd, the late senator from West Virginia would reach into his coat pocket and bring out his copy of the Constitution.

And he'd remind everybody in the room that the ability to issue debt in the name of the US government is a prerogative granted by the founding fathers to the Congress. The debt ceiling is a mechanism in which they extend that privilege to the Treasury, provided they make-- they satisfy a conditio, keep the debt under the limit.

The Congress-- the Congress isn't going to give up that prerogative. That's from the founding fathers. There's always going to be a debt ceiling. We just have to figure out a way to live with it.

JULIE HYMAN: Well, this year is not showing us that we're any closer to figuring out a way to live with events. Finally, I do want to circle back to the Fed for just a moment because I'm curious how if at all this whole debt ceiling mess, you know, is going to inform what the Fed is going to do?

VINCENT REINHART: OK. It's a really simple construct. Absent distracting drama on the debt ceiling or banks, if the Fed gets a trifecta of strong data. The economy's active-- economic activity has momentum, resources are stretched, and inflation continues to be stubborn, then they'll raise rates. So the debt ceiling matters for the next couple of weeks.

From the Fed's perspective, if it's hanging out there, it's harder for them to act. If it goes away, then they can focus more on what they really want to focus on and that is the incoming economic data. I'm not sure what they're going to do at the next meeting. You read the minutes that were published yesterday, they're not sure either.

There's heightened uncertainty. This is one of the times you can legitimately say policymakers are looking at the incoming information. There's good news though, they so hate surprising markets, they'll let us know what they're going to do at least a week before the meeting,

JULIE HYMAN: That is a very good reminder. Vincent Reinhart, good to catch up with you, Dreyfus and Mellon Chief Economist. Thanks a lot. Appreciate it.