Monetary Policy Update #7 2021

In this week’s Monetary Policy Update we analyze the latest trends in Treasury yield rates, suggesting a shift in the Federal Reserve’s attempts at keeping a lid on interest rates. We also put the threat of stagflation in a historic context.

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On U.S. Debt

Long term Treasury yield rates have peaked for now. When the rates started rising we explained that the trend, if allowed to continue, would raise rates to levels that would rapidly become unsustainable for the federal government. We have also predicted that the increase would not last, for precisely this reason.

Figure 1 reports the predicted reversal of the increase in long-term yields. It also reports an end to the downward trend in short-term yields, but the new trend there is not one of rising rates, but one of rate stability. The difference is important: if short-term yield rates were rising while long-term rates were in decline, it would suggest a strengthening of investor confidence. This appears to not be the case:

Figure 1

Source of raw data: U.S. Treasury

The stability, as opposed to increase, in short-term yields indicates a balance between supply and demand. This, in turn, implies that the Federal Reserve has not succeeded in stabilizing confidence in U.S. debt. During last year’s major expansion of the debt, the Treasury concentrated on selling shorter-term Treasurys; the central bank more than doubled its ownership of federal debt, raising prices and lowering yield on this maturity segment. During this expansion, the Federal Reserve apparently left long-term yields to the market, which – given a deterioration of confidence in the ability of Congress to meet its debt obligations – led to a rise on those yields.

It is fair to assume that the turn-around in the trend of long-term yields is due to an intervention by the Federal Reserve. This would suggest that they have shifted their purchases of Treasury debt from short-term to long-term maturities. Given that this is accurate (and we will know for certain when they release first-quarter data on their Z1 statistical series) the stabilization of short-term yields has one of two explanations:

  1. The federal government has shifted its supply toward longer maturities; or
  2. There is new demand in the short-term market that has replaced Federal Reserve intervention.

There is also the possibility that the central bank is buying debt across the maturity spectrum. To do so, however, it would have had to ramp up significantly its monetary expansion. This is an unlikely scenario, at least for the time being.

There is another player in the U.S. debt market that could explain part of the trend shifts. Depository institutions – colloquially banks – have purchased major amounts of Treasurys in the past year. According to the Federal Reserve, in the fourth quarter of 2019 banks owned almost exactly $3 trillion worth of U.S. debt. In 2020 they purchased $676.4 billion worth of debt, an expansion of 22.5 percent.

In the first quarter of 2021 they bought another $194.2 billion, putting their total ownership at $3,879.8 billion. This is a full 27.1 percent more than they owned at the end of 2019.

While public-access databases do not allow for a disaggregation of the banks’ purchases based on U.S. debt maturity, it cannot be ruled out that the depository institutions have coordinated their purchases with the Federal Reserve. This would be particularly reasonable if banks took loans from the central bank. It would also be a measure that would mimic the intervention of the European Central Bank during the 2009-2014 austerity crisis to save credit-failing governments.

Since data on bank liabilities cannot be detailed to the level where Federal Reserve loans can be identified, it is for now not possible to establish the use of this de-facto debt monetization instrument. However, given the extent with which it was used in Europe, it is a distinct possibility that it is being put to work here as well.

It is also worth noting that states and local governments also invest in U.S. debt. As we have reported previously, in the fourth quarter of 2020 they owned a total of $1,085.3 billion worth of Treasurys, up from $852.1 billion in the fourth quarter of 2019. The Federal Reserve has not yet published data on their debt purchases in Q1 of this year.

On Inflation

We have repeatedly warned of the inflationary pressure in the U.S. economy, and we recently issued a stagflation warning, in other words that we are facing a situation of high unemployment and high inflation.

Figure 2 reports inflation and unemployment since 1974. That year is chosen to mark the beginning of the 1970s experience with stagflation (during which the concept was defined). There is an important contrast between this episode and subsequent recessions:

Figure 2

Source of raw data: Bureau of Labor Statistics

The stagflation era in the late 1970s and early 1980s was, again, characterized by rising inflation (1) and high and rising unemployment (2). Three subsequent episodes have exhibited a more traditional, business-cycle based relationship between the two variables:

  • The 1990s recession (A). In the late ’80s inflation had started rising as a result of strong economic growth and a tightening labor market. As the recession began in early 1990, unemployment turned upward again. Soon after, the upward trend in inflation was broken and its rate fell from more than five percent to approximately three percent.
  • The Millennium Recession (B). During the long, strong growth period of the 1990s, when unemployment eventually dipped below four percent, inflation remained steady around three percent and even dipped briefly below two percent. That changed at the end of the decade when unemployment had fallen to the vicinity of four percent (even briefly dipping below that mark). However, the rise in inflation was brought to an abrupt end when the Millennium Recession began in 2001. Rising unemployment was coupled with declining inflation.
  • The Great Recession (C). The pattern from the 1980s and 1990s roughly repeated itself in the 2000s, with unemployment declining and the inflation rate slowly picking up again. As the recession began in late 2008, the two variables once again reversed their trends as in the previous recessions, albeit more abruptly this time.

Since the last recession, inflation has had a hard time even reaching two percent. Generally, the latest rate observed, 2.6 percent in March, should not be anything to worry about. However, for two reasons the current rise in inflation is reason for concern:

  1. The monetization of the federal deficit has created monetary pressure upward on prices, a pressure that has not eased over time. This is the monetized inflation gap, which artificially injects purchasing power into the economy; the artificial component consist of value being added to the absorption side of the economy without corresponding value being added on the production side.
  2. Producer prices have been rising sharply in recent months. When adjusted for the artificial economic shutdown last year, the annual increase in the producer price index in March was only a hair shy of ten percent. Producer price inflation causes consumer price inflation, generally with a two-month lag. Due to accelerating producer-price inflation in February and March, we can expect higher consumer price inflation in April and May than the 2.6 percent observed in March.

The uptick in inflation is happening while unemployment remains above six percent. This rate appears to be stable; in August last year, when the economy started emerging from the artificial economic shutdown, unemployment fell to 8.5 percent from 10.5 in July. It declined further to 7.7 percent in September and 6.6 percent in October. Since then it has averaged 6.5 percent; it remains to be seen if the 6.2-percent rate in March – down from 6.6 percent in February – is a temporary or permanent improvement.

The worry is that as our current inflation rate of 2.6 percent is followed by higher rates, unemployment remains stuck above six percent. The macroeconomic consequences are significant, especially if stagflation is paired with a continued expansion of the federal debt.