The Federal Reserve has started winding down its program for buying Treasury securities. Has this caused a rise in interest rates?
On Wednesday, the Federal Reserve announced that it has begun tapering its monetary stimulus. This is one month earlier than what members of the Federal Open Market Committee had stated previously. The tapering is also more aggressive than expected, which tells us that the Fed has good reasons to be quite worried about the near to mid-term future of the U.S. economy.
Before I explain what the reasons are for those worries, let us take a look at the announcement itself. The November 3 FOMC statement started with the expectable formalities:
The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With inflation having run persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent.
Again, this is mostly sausage filling. Currently, inflation is significantly higher than two percent, and still trending upward. Next week the Bureau of Labor Statistics will release October numbers for the Producer and Consumer Price Indexes, likely showing yet more inflation. The FOMC refers to its inflation target simply because it is one of their policy goals. However, they also took the opportunity to use this as a reference point, to anticipate the pain that some might feel as they move deeper into their announcement. Hence, explains the FOMC:
The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved. The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.
In other words, the Committee is trying to ease fears of interest rates rising as a result of their drawdown of Treasury debt purchases. Here is why:
- When you tighten monetary policy, theoretically the supply of liquidity in the economy falls relative demand, causing the price of liquidity to rise;
- The price of liquidity is also known as the interest rate; the mechanics that causes the interest rate to rise are to be found on the sovereign-debt market, where a reduction in demand for bonds causes prices of bonds to fall, which automatically raises the interest rate;*
- When the Fed reduces its purchases of U.S. debt and interest rates start rising, the Treasury will have to spend more just to maintain the debt it has.
What is the result of that? Congress must allocate more money to paying interest on its debt, and with the Fed drawing down its Treasury purchases there will be less liquidity in the market. This will force Congress to abandon its current, open-ended fiscal policy and instead pay more attention to what it spends money on, and how it pays for that spending.
In other words, the FOMC’s mentioning of the federal funds rate is a political statement, meant to neutralize criticism that its tapering will force fiscal policy in a more conservative direction.
With that qualification in place, the Committee gets to the meat of its announcement:
In light of the substantial further progress the economy has made toward the Committee’s goals since last December, the Committee decided to begin reducing the monthly pace of its net asset purchases by $10 billion for Treasury securities and $5 billion for agency mortgage-backed securities. Beginning later this month, the Committee will increase its holdings of Treasury securities by at least $70 billion per month and of agency mortgage‑backed securities by at least $35 billion per month. Beginning in December, the Committee will increase its holdings of Treasury securities by at least $60 billion per month and of agency mortgage-backed securities by at least $30 billion per month.
And now for the big one:
The Committee judges that similar reductions in the pace of net asset purchases will likely be appropriate each month, but it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook.
Plainly: unless something really serious happens, they will continue their drawdown until they wrap it up in May. The tapering is now their default monetary policy.
The policy shift that was originally planned for December happened in November for three reasons.
The first is to be found in the scenario I outlined yesterday for what a fiscal crisis in America would actually look like. They know this is a real possibility, and it is likely that the Democrats’ plans for another round of enormous, deficit-funded spending – including major new entitlement programs that would add permanent deficit-funded spending to the federal budget – has gotten the Federal Reserve so worried that they felt it necessary to take action as soon as they possibly could. The FOMC announcement coincided conspicuously with plans in Congress to vote on massive spending bills.
In other words, this is the Fed’s payback for radicals in Congress demanding that the President replace Jerome Powell as Fed Chairman with someone who is sympathetic to, perhaps even an open proponent of Modern Monetary Theory. By starting its debt-purchase rollback just before the radical left’s big spending bills were up for a vote, the FOMC raised the price for those bills to a point where they may now be unpalatable even to mainstream Democrat legislators.
The FOMC would do this not because it is particularly protective of Jerome Powell’s job, but because they are genuinely worried about the radical fiscal agenda sending America rocketing into a fiscal crisis. In this sense, the Fed has taken responsibility for the country; as I noted recently, the Federal Reserve in general, and its chairman in particular, represent the last hope for America as a first-world, prosperous nation. I reinforced this point in yesterday’s article about what a fiscal crisis would actually look like.
If the first reason for the Fed to rocket-launch its tapering is related to fiscal policy, the second rests on a more classical monetary policy motive. Inflation is here and it is not going away, with third-quarter GDP numbers showing inflation close to five percent. And let’s not forget that the GDP-based inflation measurement is more conservative than the more widely used Consumer Price Index, the October numbers of which the Bureau of Labor Statistics will publish next week.
It is entirely possible, even likely, that the Fed, having a preview of those numbers, got so scared of where inflation is heading that they decided it was reason enough to move faster with their rollback of Treasury purchases. If so, we should expect a bombshell or two on Tuesday and Wednesday when PPI and CPI numbers are released.
The third reason for the Fed’s ramp-up is likely anticipatory: they know that as more adverse economic data is released, there will be shock reactions on key markets. Bad inflation numbers tend to drive up interest rates; if investors and analysts connect the inflation numbers to the Fed’s accommodating monetary policy, a delay in the tapering, and a moderate tapering when it eventually begins, will only add fuel to the concerns that drive up interest rates. Therefore, if you are going to shift from a policy of monetary accommodation to a policy of monetary tightening, it is wiser to do it slowly and gradually than to do it rapidly and risk interest-rate shocks.
With all that said, there is an oddity embedded in all this: the FOMC wants to tighten money supply while keeping interest rates unchanged. This is a contradiction in terms: the Fed can either control money supply or interest rates, but not both. All the members of the FOMC know this, and they know that analysts will see it as well, which makes their stated contradictory ambition even more curious. The superficial motive, to ease criticism from the radical left, is only a small part of the story; the deeper motive is embedded in the following sentence, which concludes the FOMC’s announcement paragraph:
The Federal Reserve’s ongoing purchases and holdings of securities will continue to foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses.
In short: the Fed is going to use indirect measures to ease the market reactions to its policy shift. By definition, it cannot do this without maintaining an expansionary monetary policy, but if that policy runs through other channels than deficit monetization, it will supposedly have less adverse effects on interest rates.
If this sounds cryptic, don’t be alarmed. I will discuss it in a lot more detail after the weekend.
*) The exact reason for this is that the Treasury security is a fixed-income asset: it pays $X per year. If the yield is $1 and you buy it for $50, you get two percent return on your investment; if you buy it for $100, you get one percent. When demand declines, sellers have to lower the price to unload their securities, hence the rise in interest rates.
Labor compensation is outpacing labor productivity.
Over time, this leads to either job losses or inflation. Or both:
The following is a scenario for a U.S. fiscal crisis. It is based on my two articles on the history of the Treasury debt and on who owns the debt. It also draws on my own research on the fiscal crises in Europe a decade ago.
Friends: this is no longer a hypothetical issue. It is no longer something we can ignore and leave for another day. This is a real problem, and unless Congress acts very soon, the inflation and economic disruptions we have seen so far this year will be a walk in the park by comparison.
Let me stress this again: my scenario is a realistic one. As you read through it, please keep in mind what the consequences will be for each and everyone of us. Then please consider what you can do to convince your U.S. Senators and Representatives to do everything in their power to bring our budget deficit under control.
A Crisis Like No Other
The crisis is preceded by another spending bill being passed by Congress – it doesn’t really matter what the spending bill is, except that it is large and adds permanently increases the budget deficit. When it is clear that the bill will be signed by the president, sovereign-debt investors react to it at the next Treasury auction by not buying all the debt the Treasury is trying to sell.
As my good friend and fellow expert with Compact for America, Baker Spring, has explained, this is the “trigger point” for a fiscal crisis. The news that the Treasury could not unload all its debt at the latest auction rapidly spreads through the financial markets and hits the top of the news cycle. The Treasury Secretary tries hard to play down the negative message, but investors and analysts do not believe her.
News leaks about a panic meeting between the Treasury Secretary and the Chairman of the Federal Reserve. The Secretary demands that the Chairman abandon the central bank’s newly adopted monetary conservatism and again commit to accommodating the budget deficits. The Chairman points to the high inflation rates and steadfastly refuses to relent.
The majority of the Federal Open Market Committee stands behind the Chairman, but two of its members – proponents of MMT appointed by President Biden – openly voice their dissent. Radical members of Congress echo their views, demanding that the president fire the Chairman and replace him with a monetary expansionist. The president does not comment on the matter, but the Treasury Secretary hints of some support for the radicals.
Media speculation about the future of the Chairman of the Federal Reserve exacerbates the turmoil caused by the radical rhetoric. The silence from the president on the independence of the central bank adds insult to injury. Meanwhile, the Treasury, eager to restore investor confidence, announces an extra ordinary debt auction and unofficially promising to offer higher yields. This is in effect a promise to raise interest rates to attract more buyers, and to further increase the chances of selling the debt, they increase the supply of long-term debt and offer generous rates in return.
This is a break with Treasury tradition: normally it manages its rising borrowing needs by expanding the supply of short-term debt, i.e., bills. The Treasury Secretary refers to the stagflation episode in the early 1980s, pointing out that back then, investors absorbed high-yielding long-term debt because they were confident that inflation would subside and the high yield would be profitable. This, however, is not how the market responds this time: during the stagflation era the president and Congress recognized the independence of the Federal Reserve. Since that does not seem to be the case this time, investors point out, they refuse to buy enough of the long-term debt to sell out the auction.
Having been left with unsold securities at two auctions in a row, the Treasury is now in full-fledged panic. They turn to states, begging them to open their purses and buy non-marketable securities. However, due to inflation and a stalled economy, states are almost universally wrestling with fiscal problems of their own. The amount they are willing to buy is nowhere near what the Treasury needs to sell immediately, let alone enough to help restore market confidence in the debt.
One of the major international credit rating agencies announces that it will now downgrade U.S. debt. Another agency announces a “review”. This immediately causes foreign investors, who own about one quarter of U.S. debt, to raise concerns about what this will do to the value of the dollar. Even if their investments remain unchanged in U.S. currency, a dollar depreciation would inflict losses on them anyway.
As a result, term trade in the dollar rises rapidly, but the trend that emerges is one of expectations of a weaker dollar. Foreign investors start selling U.S. debt; normally, the money would go into the stock market, but due to the stalled economy and high inflation the outlook for stock portfolios is weak. The dollar declines.
When the U.S. currency declines, forecasts emerge that suggest yet more inflation to come. Since inflation was one of the factors triggering the crisis in the first place, this only adds to the negative outlook that got the snowball moving. The radicals in Congress double down on their demands that the Fed print all the money needed to bankroll the Treasury, but at this point conservatives and moderates counter with their own plan: suspend the latest spending bills.
Meanwhile, the Treasury, desperate to rake in cash from selling debt, goes back to the market with a big pile of bills. These securities, with a maturity of one year or less, are dominated by 1-3 month bills and come with interest rates in excess of six percent. The package is good enough to sell out the auction, but with the majority of the bills maturing very soon, everyone knows the Treasury will soon be back at square one again.
The rise in rates on Treasurys has direct consequences for banks. With U.S. debt accounting for one fifth of their assets, they now see an opportunity to restructure their portfolios. However, as they do, they also push interest rates up across the board: car loans, mortgages, personal lines of credit, etc., are suddenly slated to become a lot more expensive. The combination of rising inflation and the outlook of rising interest rates causes both families and business owners to call their representatives in Congress and voice loud complaints.
So far, the president has not made any major statements on the crisis. The Treasury Secretary has been forced to take the heat and deal with it on a day-to-day basis. Pushed to the brink by two failed auctions and one that barely sold out, the Secretary is now under enormous stress and asks the President for support. Motivated more by falling poll numbers than pleas from the Secretary, the President gives a speech promising to “work with Congress” to solve the problems plaguing the nation. It is unclear what faction of Congress the President will work with, but unofficially the White House expresses support for the suspension of the latest spending bills.
At this point, however, it is clear that the Treasury sell-off by foreign investors, followed by a complete halt in purchases by states and local governments, far outweighs any extra purchases by banks. The Fed’s steadfast refusal to re-enter the sovereign-debt market is seen as encouraging by some analysts and investors, but adds to the downward pressure on Treasury prices, and therefore to the upward pressure on interest rates. The highest yields are now touching ten percent.
Encouraged by at least implicit support from the President, but gravely worried about both inflation and interest rates parking themselves above ten percent, moderates in Congress go to work on a plan to not only suspend the latest spending bills but also to actually make cuts in current spending. Since entitlements account for 70 percent of the federal budget, everything is on the chopping block, from Medicaid reimbursement rates and benefits to a drastic reduction in child-care tax credits and the EITC. This enrages the radicals, who do everything they can to sabotage the process.
The gridlock on Capitol Hill is widely broadcast by media. Investors maintain that they are unimpressed and will continue to downsize their holdings of U.S. debt. The dollar falls yet again, and to avoid a run on the currency the Fed starts selling off part of its foreign-currency reserves to support the dollar. This unheard-of move by the U.S. central bank – never in history has the Fed had to buy its own currency for the explicit purpose of stabilizing its exchange rate – is viewed as reassuring over the short term, but also serves to underscore the gravity of the crisis. While foreign sell-off of U.S. debt wind down, investors see the Fed’s unique move as yet another sign that U.S. debt is not to be trusted.
Demands once again emerge for higher interest rates at the next Treasury auction. The Treasury has no other way to go but compliance: rates now exceed ten percent across the maturity spectrum, with the highest ones touching 15 percent.
At this point, the MMT proponents on the Federal Reserve’s Open Market Committee vocally renew their demands that the central bank intervene in the market. They are joined by Congressional radicals who promise to let the moderats raise taxes “on the rich” and cut some benefits for “higher income families” if the President fires the Chairman of the Federal Reserve and appoints an MMT supporter instead. If the President refuses, the radicals hint, there will be violence in the streets of America’s major cities.
Pushed into a corner by inaction and failure of leadership, the President is left with only two choices:
- Comply with the radicals and make the Fed go all out to monetize budget deficits. The reactions from sovereign-debt investors will be ferocious, with a massive foreign sell-off, a collapse of the dollar and the realistic outlook of inflation rates in excess of 50 percent per year.
- Stick by the Fed chairman, defy the radicals and work with the moderates to cut spending. The problem with this strategy is that the spending cuts have to be massive, and immediate: a temporary but full suspension of the EITC, cuts of 20-30 percent in Medicaid benefits, the grounding and “porting” of U.S. armed forces with military furloughs in the thousands, a federal sales tax of five percent, plus a five percentage-point increase in federal personal income taxes for everyone making $50,000 or more.
What will the president do?
Consumer spending is reverting back to its long-term normal, and that is more bad news from the Biden economy:
While conservatives are celebrating the strong performance of Republican gubernatorial candidates in Virginia and New Jersey, the U.S. economy continues to steam toward the iceberg known as a fiscal crisis. It is possible that yesterday’s election results precipitate a Republican takeover of both chambers in Congress next year, and it is also possible that the very prospect of this majority shift will have a positive impact on confidence in U.S. debt, but any such changes would be mere speculation at this point. Republicans don’t exactly hold a stellar record when it comes to fiscal responsibility, and it is entirely plausible, perhaps even likely, that the Democrats will ramp up their attempts to get major, fiscally destructive spending bills through Congress over the next 12 months.
If the Democrats succeed in creating more entitlement programs, the budget deficit would quickly spin out of control. However, even without the addition of massive new spending programs, the fiscal situation of the federal government is bad enough that we should prepare ourselves for a fiscal crisis to happen within the next two years. Its consequences would be enormous, with no part of the economy left untouched; if the crisis were to include a default on U.S. debt – if even partial – those who own it will of course take the biggest hit.
This point is actually sometimes floated in the debate. Without giving any room to default proponents, let me just make a generic reference to arguments favoring a partial default on debt owned by China. Not only is this highly questionable from a legal viewpoint, but the suggestion is also an exhibit of a major lack of understanding of how sovereign-debt markets work: as far as investors are concerned there is no such thing as a partial debt default. If a debtor can default on debt owned to one creditor, it can default on what it owes to every other creditor out there.
So, if it actually comes to a debt default, who would it hurt? To start with foreigners, the $7.5 trillion that they own is distributed as follows:
- Japan: $1,320 billion
- China: $1,047 billion
- United Kingdom: $569 billion
- Ireland: $326 billion
- Switzerland: $295 billion
- All other: $3,557 billion
In other words, the five largest foreign owners account for 50 percent of the rest-of-the-world share of U.S. debt. China owns less than 14 percent of that share, and they own only about 3.5 percent of total U.S. debt. Their share is smaller than the share owned by U.S. states and local governments. All in all, foreigners own just over one quarter of total U.S. debt and approximately 29 percent of its public share. This makes foreign investors a significant creditor for the federal government, but as Figure 1 reports, their share has been shrinking of recent. The Federal Reserve is expanding its ownership, as are U.S. banks.
Behold the shares of publicly owned federal debt since the 1950s:
As of the second quarter of this year, global investors owned $7.2 trillion worth of publicly traded U.S. debt. The Federal Reserve came in a close second with $5.6 trillion. Households, private depository institutions and non-federal governments each account for a bit over $1.3 trillion. This means that practically every corner of the U.S. economy, and a fair portion of the global economy, would feel the pain if the Treasury reached a point where it had to either postpone debt-obligation payments or unilaterally write down its own debt.
Neither option should even be on the table, and so far the debt-default advocates are only found on the fringe of the public discourse. However, that was also the case with Greece prior to its partial debt default almost a decade ago. Once the fiscal crisis brings the debt-default issue out of the closet, things can move very fast. What was unthinkable on Monday can be a matter of fact on Friday. Furthermore, the very structure of U.S. debt ownership contributes to the likelihood that Congress, when it has painted itself into a fiscal-crisis corner, will use a partial default to get out. As Figure 1 explains, prior to the 1970s America’s families were important investors in government debt: in the 1950s and 1960s, they owned 27-30 percent of all U.S. Treasurys. Once Lyndon Johnson’s War on Poverty had transformed the American welfare state into a machine for economic redistribution, that share dropped precipitously. Today, as mentioned, households own about $5.50 of every $100 worth of U.S. government debt.
Our banks have also become less important, relatively speaking. Their ownership share has evolved roughly in the same way as that of individuals. With foreigners and the Federal Reserve replacing them as the major creditors for the Treasury, it looks risk-free for Congress to default on its debt; the constituents who could complain over a default have been pushed out into the margins.
While I have no direct evidence that anyone in Congress is reasoning along these lines, there are major political incentives in place that point in this very direction. It is essential to note, therefore, that while households and banks may be small as owners of U.S. debt, the debt they own is not insignificant to them. Figure 2 reports Treasurys – both those backed by mortgages and those that aren’t – as share of total bank assets:
Federal government debt accounts for about one fifth of U.S. bank assets. This share has increased rapidly over the past few years: in three short years they have doubled their ownership, in current-price dollars, and elevated federal government debt from 15 percent of their assets to 20 percent.
You do not have to be a finance specialist to realize the repercussions for our banking system, should such a large debtor as the U.S. government fail on even some of its debt. In the next article on our government debt I will discuss what this means in terms of how a fiscal crisis would unfold.
A teaser: you won’t want to read it as a bedtime story.