Economy
Do Not Trust Governments with the Control of Money
Unfortunately, the benefit of a gold standard has not been that it has always effectively prevented government monetary mismanagement and abuse; far from it.
Penned by Richard M. Ebeling at American Institute for Economic Research
If there one thing that is fairly certain in this life – besides the seeming inescapability of death and taxes – is that once someone is appointed to almost any position in the political and bureaucratic structures of a government they soon discover how important and essential is the organization of which they are a part for the well-being of the nation. The country could not exist without it, along with its increasing budget and expanded authority. This applies to the Federal Reserve, America’s central bank, no less than other parts of government.
The news media has reported that the apparently unlikely appointment of Dr. Judy Shelton to the Federal Reserve Board of Governors probably will be successfully maneuvered through the full Senate confirmation process. Shelton would then sit on the Federal Reserve Board for a 14-year term. Hers has been one of the more controversial nominations to the Fed in recent years, with critics fervently expressing their negative views of her.
For instance, Tony Fratto, a former Treasury official and deputy press secretary under George W. Bush, was recently quoted as saying that Shelton’s appointment would be “a discredit to the Senate and the Fed. It screams. Nothing at all is serious. Not us. Not you. Not them.”
Mainstream Economists Against Anyone for Gold
Back in August of this year, over one hundred academic and business economists issued an open letter to members of the U.S. Senate calling for rejection of her nomination to the Fed. Among those who signed were some economics Nobel Laureates, including Robert Lucas and Joseph Stiglitz. They insisted on her unfitness for such an appointment. Why? They said: “She has advocated a return to the gold standard; she has questioned the need for federal deposit insurance; she has even questioned the need for a central bank at all.”
They also accused her of hypocrisy, saying that Shelton had changed her stance on Federal Reserve policy and the institution’s relevance based simply on a desire to be appointed to the Fed board, and to serve the wishes of the president who had nominated her. So, she stands damned if she opposes the Fed with her call for a gold-backed currency, and she is damned if she modifies her positions on monetary policy supposedly to be more palatable to the Senators deciding her professional fate. Clearly, her critics would only stop being critical if they were somehow convinced that Judy Shelton truly loved the Fed, hated the gold standard, and supported “activist” monetary policy and interest rate manipulation; and for the full 14 years of her term on the Fed Board.
Political campaigns are full of people who say that they are drawn to higher echelon government employment so they can “give back” to or “serve” the country, and no doubt there are some who are seriously sincere when they say so. But who can deny that what also appeals to such people, and many others who are far more crudely opportunistic, is the attraction of being a “player” and an “insider” in the various halls of political power and decision-making in determining the bigger picture of the “shape-of-things-to-come?”
And it may be that Judy Shelton, based on her own statements of desiring to “serve” the country in this particular capacity, truly wants to, even with all her apparent changing views and emphases. Or maybe it’s all a game to say what she thinks others want and need to hear so that will approve her as a Board member of the Federal Reserve, and then sit at the Big Boy’s – oh, I mean the Big Person’s – table.
The Real Issue is the Case for Gold, Not a Person’s Sincerity
Be that as it may, the real issues concern whether her views on gold and the Federal Reserve are reasonable or not as useful input into the decision-making process of Fed monetary policy. To begin with, there is a far longer history of human societies going back to the ancients in which gold or silver or some other “real” commodity has served as the medium of exchange, the money-good facilitating transactions. The period of history in which mankind has primarily relied upon fiat or paper money currencies only covers about the last one hundred years.
Now, merely because an idea or an institution has been around a long time does not prove its validity or continuing usefulness. A variety of bad ideas and bad institutions beclouded human betterment for many centuries until they were finally overturned and replaced by other ideas and institutions considered more in line with bringing about improvements in the human social, economic, and political condition.
Fundamentally, the case for a gold standard has been based on the idea that governments have been notorious in the misuse of their capacity to turn the handle of the monetary printing press to create the money needed to fund their expenditures, rather than fully rely upon the collection of taxes. By this means, governments are able to get around the necessity of telling their citizens the truth concerning the actual cost of the activities it wishes to undertake. This was understood by many economists of differing policy persuasions.
“Progressive” Richard T. Ely Challenged Arbitrary Monetary Policy
As an example, Richard T. Ely (1854-1943) is usually viewed as one of the early and successful proponents of the interventionist-welfare state in America in the late 19th and early 20th centuries. Having earned his bachelor’s and master’s degrees at Columbia University in New York in the second half of the 1870s, he went off to complete his studies in Imperial Germany. He came back imbued with the economic ideas and policy prescriptions of the German Historical School, with its emphasis on pragmatism and expediency as the needed basis for guiding governments in regulating industry and pursuing various forms of redistribution of wealth. He was also one of the founders of the American Economic Association in 1885 and a leading figure in the American Progressive Movement in the 1890s and early decades of the 20th century.
In his co-authored textbook, Outlines of Economics (1893, 4th revised ed. 1926) Ely highlighted the abuse with which governments – including the U.S. government during the Civil War of the 1860s – had used the issuance of paper or fiat money to fund expenditures with serious inflationary consequences for the citizens of countries experiencing such dangerous power by those in political authority. And why governments have little or no incentive to ever rein in their monetary mischiefs:
“The supply of gold, as we have seen, is subject to variations arising from such influences as the discovery of new deposits, the exhaustion of old ones, and changes in the methods of handling the ores. Variations in gold production are reflected in movements of the general level of prices.
“The supply of fiat money, it is argued, could be arbitrarily controlled by government and its purchasing power could be kept more nearly stable. Closely scrutinized, this particular argument for fiat money turns into the strongest of the arguments against it. Under practical conditions, experience has shown, governments find it much easier to expand than to contract their issues of paper money.
“Expansion permits larger expenditures; it is, for the time being a substitute for taxation; it raises prices and stimulates business. Contraction on the other hand, is at the expense of an immediate increase in taxation; it calls for rigid economy on the part of the government; it has for the time being a depressing effect upon business activities.
“With all of its shortcomings, the gold standard has the great advantage that its variations, largely the result of the play of the forces of the market, are beyond the arbitrary control of government.” (p. 259)
J. Laurence Laughlin and the Perverse Incentives of Paper Money
We may use one more example, but this time by an economist with nearly the exact opposite of Richard Ely’s public policy views. J. Laurence Laughlin (1850-1933) earned his PhD from Harvard University, and became a founder of the economics department at the University of Chicago in 1892. He was an advocate of the establishment of a central bank in the United States in the years leading up to the opening of the Federal Reserve in 1914. He is also often considered a critic of the traditional quantity theory of money. On general matters of economic policy, Laughlin was a strong proponent of a general laissez-faire, free market society.
In his Money and Prices (1919), Laughlin also emphasized the danger of paper currencies not connected to gold by redemption requirements to prevent governments from taking advantage of their capacity to increase the amount of paper money in circulation:
“The very existence of paper [money] issues, originating in a wrong method of borrowing [by the government], is a constant menace. The mere lapse of time in which no injury has been incurred unfortunately serves to lull the fear of anger. If retained, such issues are a suggestion for similar crude expansions in the future, when men are too excited to judge calmly of their acts. Their very presence is an incentive.
“If legislators were all monetary experts, and never influenced by political considerations, there would be little risk in retaining for a time [such fiat money]; but we must take men as they are, and provide for probable acts of those who are incompetent and ill-advised. Obviously, these national guardians of our monetary system do not personally lose anything when they get the treasury into desperate straits . . .
“What is still more dangerous is the fact that the whim of the government is the only limit to its [paper money] issues . . . If a fancied need presses upon men inexperienced in monetary operations, especially if they have been inoculated with the fallacy that the more money a country has the better off it is, there will be excessive issues, followed by raids on the reserves.
“The paper will depreciate – and the country will undergo rapid fluctuations in prices, an unsettling of contracts, a period of mad speculation, leading to the inevitable ruin of a commercial crisis . . . It being understood [therefore] that convertibility into gold is the prime prerequisite either of government or bank issues.” (pp. 265-266; 274)
The 20th Century Failures of Paper Money Systems
Is there anything in the history of the last one hundred years to invalidate the questions and concerns of such economists as Richard T. Ely or J. Laurence Laughlin, from so long ago, that led them to support and argue for a gold standard on political grounds? There was the monetary madness during and after the First World War, with paper money inflations to fund the expenses of the belligerent powers, and the destructive hyperinflations that followed the end of that conflict. (See my article, “The Lasting Legacies of World War I: Big Government, Paper Money and Inflation”.)
There was the false sense of economic and monetary stability in the 1920s, followed by the Great Depression due to misguided Federal Reserve policy in the ’20s and disruptive government interventions and centralized planning schemes in the decade of the 1930s. Then more inflations to finance the Second World War, with a rollercoaster of inflations and recessions in the post-World War II period, followed by the new Federal Reserve monetary mismanagements that led to the financial and housing crises of 2008-2009, with continuing monetary manipulation over the next ten years of economic recovery. (See my article, “Ten Years On: Recession, Recovery and the Regulatory State”.)
Institutions Restrict Potentially Harmful Behavior
Unfortunately, the benefit of a gold standard has not been that it has always effectively prevented government monetary mismanagement and abuse; far from it. But, like many social, economic and political institutions, it sets limits and rules on the conduct of the societal participants that restrict everyday conduct that if allowed and regularly pursued can bring about changes in attitudes and actions that cumulatively brings damage to all in society.
It can be easily argued that John Maynard Keynes’s “revolutionary” idea of governments balancing their budget over the business cycle – budget deficits in ‘bad” times and budget surpluses in “good” years – rather than on an annualized basis set loose the perverse political incentives of politicians never having to completely tell the citizenry from whence will come all the revenues to cover the costs of increasing government expenditures with which campaign contributions and votes are bought by politicians in the never-ending election cycles of modern democratic society. This institutional change has led to U.S. government budget deficits for 63 of the last 75 years since the end of the Second World War in 1945, with, now, annual trillion-dollar budget deficits likely to be the norm for as far as the fiscal eye can see. (See my articles, “Why Government Deficits and Debt Do Matter” and “Debt and Deficits are Out of Control” and “Debt, Deficits and the Cost of Free Lunches”.)
The same has happened with mismanagement of the monetary system with, first, the weakening of the gold standard during and after the First World War, and then its abandonment in one country after the other beginning in the 1930s. The world is on fiat or paper money standards with total control in the hands of various monetary central planners with little or no external check on their policy decisions, other than the particular monetary theory fads and fashions that central bankers and their staff economic advisors currently hold as a guide for actual policy actions; along with the pressures of contemporary politics, regardless of how much it may be formally punctuated that the leading central banks around the world make their policy choices independent of the political climate.
Not having to worry about mandatory redemption of the bank notes and other monetary equivalents they issue being paid in gold “on demand” at a fixed rate of exchange by either domestic or foreign holders of their fiat currencies, central banks have been able to set loose what more than one economist has called the “age of inflation” since the end of the Second World War.
Gold an International Money vs. Fluctuating Paper Currencies
The end to the gold standard also weakened the international quality of what had been in many ways a global monetary system in which gold was the world’s money and national currencies were merely different denominational ways of expressing relative amounts of the same money good.
The French social philosopher, political economist, and “futurist,” Bertrand de Jouvenel (1903-1987), in an article on “Money in the Market” (1955), recounted the experience of a British family vacationing in France before and then after the end of the gold standard in the 1930s:
“In 1912, an English family spent its summer holiday in an out-of-the-way French village. A bill was presented, invoiced in francs; the English father had nothing but English gold sovereigns, then in circulation in Britain. This did not embarrass the innkeeper; true, he had never seen coins stamped with the British Monarch’s profile, but he was thoroughly familiar with the gold coins then circulating in France.
“Placing a 20-franc gold piece by the side of the sovereign, he found the latter heavier (123.27 grains to 99.56) and it seemed to him that two sovereigns made up about the same weight as a 50-franc gold piece (50 francs = 248.9 grains; 2 sovereigns = 246.54). Therefore, without consulting anybody, he made up his mind to accept two sovereigns as equivalent to 50 francs . . .
“In 1932, the same English family returned to the same spot, again the head of the family had no other means of payment than those current in Britain at the time, i.e., pound notes. The aged innkeeper took these notes, laid them side by side with French notes, and this time learned nothing from the comparison . . . The ‘weighing’ of pounds had ceased to be a physical process, it was now a market process, a day-by-day confrontation of the French demand for pounds with the British demand for francs.
“In the former case the rate of exchange depended upon the unchanging balance of physical weights in fine gold between the national coins: it was therefore inherently stable; in the second case it depended upon the changing balance of claims between two countries . . . it was therefore inherently unstable.” (See Bertrand de Jouvenel, Economics of the Good Life [Transaction Publishers, 1999], pp. 179-180.)
The Changing Opinions of Economists on Monetary Policy
When Great Britain in 1931 and then the United States in 1933 went off the gold standard, there was much hue and cry among a large majority of economists and many in the general public that a terrible policy mistake had been made in ending gold as the core money based on obligatory redemption of bank notes into a fixed weight of gold.
No doubt, the economists who issued that open letter in August of 2020 angrily protesting to the U.S. Senate their objection to Judy Shelton’s nomination to the Federal Reserve Board of Governors would all consider it the essence of monetary policy wisdom in the 1930s to have freed the British and American monetary systems from what Keynes had in the 1920s called that “barbarous relic” – gold.
By implication they would also be saying how misguided and wrong-headed were all those economists of the 1930s to oppose the leaving of the gold standard so governments might have wider discretion to wield monetary policy in the “activist” attempt to overcome the Great Depression.
Let me suggest that it is not outside the realm of the possible, perhaps the probable, that 50 years from now, many, maybe a significant majority, of economists will look upon the signers of that letter and think how misguided and foolish they were in thinking that governments and their central bankers had the knowledge, wisdom and ability to micromanage the economy through the macro-manipulation of money, credit and interest rates.
The Freedom to Choose the Currency to Use
They will wonder how it was that so many in the economics profession could have suffered from the delusion that monetary central planning ever could be any more feasible than the failed Soviet-style system of general central planning of human affairs. Those future economists will be confounded that these economists of 2020 had not paid more attention to the reasoning of Austrian economist and Nobel Prize-winner, Friedrich A. Hayek (1899-1992), when he pointed out that nothing had been more wrong-headed than leaving the control of money in the monopoly hands of government.
That, as Hayek had argued in Choice in Currency (1976), nothing would be more reasonable and rational than letting everyone, anywhere, choose the money or monies that they found more convenient and advantageous to use in various and sundry transactions and exchanges. That such freedom to choose would be an invaluable institutional means to keep government monetary mismanagement and abuse in check, since any political authority which noticeably reduced the value or increased the uncertainty of its national currency’s future worth, would see a flight out of its use by its own and other citizens of the world. (See my article, “Government Monopoly Money vs. Personal Choice in Currency”.)
Indeed, those future economists may also wonder why it was so difficult for those earlier economists of 2020 to fully appreciate the value and effectiveness of private competitive free banking as a replacement for the atavistic notion that a central bank was either necessary or desirable. They will be surprised at the general ignoring of an entire sub-field of monetary theorists that had emerged in the late 20th and early 21st centuries who demonstrated why central banks were the very institutional instrument to propagate the types of instabilities that monetary central planning was supposed to eliminate, or at least reduce. And why and how it was that the very stability and feedback needed for a functioning and growing economic order to flourish was far more likely and possible through monetary freedom. (See my eBook, Monetary Central Planning and the State.)
And who knows, if Judy Shelton is appointed to the Federal Reserve Board of Governors, and if she actually espouses and defends the ideas for which she is being condemned by so many of those “mainstream” economists today, it may be a useful step to the societal transformation to a freer society, a key long run element of which must be the freeing of money from political control.
Economy
McMaken: The Fed’s Inflation Is Behind the Supply-Chain Mess
… the idea that supply chain problems are “driving inflation” gets the causation backward.
It seems supporters of the Biden Administration finally settled on a narrative they like for explaining away supply chain shortages.
Here’s the administration’s talking point: the US economy is rolling along so well that Americans are demanding huge amounts of goods. That’s overwhelming the supply chain and causing the back-ups roiling America’s ports and logistic infrastructure.
For example, Transportation Secretary Buttigieg this month declared “Demand is up … because income is up, because the president has successfully guided this economy out of the teeth of a terrifying recession.”
Similarly, White House spokeswoman Jen Psaki told reporters supply chain problems are occurring because “people have more money … their wages are up…“we’ve seen an economic recovery that is underway…”
This position has been mocked by a number of conservative politicians—including Senator Ted Cruz—and commentators who find this to be an absurd assumption.
Yet, the administrator’s defenders aren’t totally wrong. As Mihai Macovei showed earlier this month, the global volume of trade and shipping volume in 2021 have actually exceeded pre-pandemic numbers. For example, in the port of Los Angeles, “loaded imports” and “total imports” for the 2020-2021 fiscal year (ending June 30, 2021) were both up when compared to the same period of the 2018-2019 fiscal year.
In other words, it’s not as if nothing’s moving through these ports. In fact, more is moving through them than ever before. That suggests demand is indeed higher.
But why is it higher? It some ways, it’s true that, as Psaki says, people have more money.
But that’s where the veracity and usefulness of Biden’s defenders end in explaining the problem.
Much of the answer can be found in monetary inflation. Obviously, Joe Biden hasn’t “successfully guided the economy” through anything, but it is accurate to say that people have more money in a nominal sense. Wages are up nominally. After all, if we look at the immense amount of new money created over the past 18 months, we should absolutely expect people to have more money sloshing around. But this also means a lot more pressure on the logistical infrastructure as people buy up more consumer goods.
In other words, the idea that supply chain problems are “driving inflation” gets the causation backward. It’s money-supply inflation that’s causing much of the supply chain’s problems. Not the other way around.
After all, since February 2020, M2 has increased from $15.2 trillion to $20.9 trillion in September 2021. That’s an increase of 35 percent. Yes, some of that has been kept within the banking system through the Fed’s payment of interest on reserves, but a lot of it clearly has entered the “real economy” through stimulus payments, unemployment insurance, and federal deficit spending in general.
Originally, the public was saving a lot of that stimulus and bailout money, with the personal savings rate hitting historic highs of over 25 percent. But this past summer the savings rate collapsed again, and as of September is back under eight percent. The public is now flooding the economy with its former savings.
The American appetite for spending on consumer goods hasn’t gone away. Yet, there are many reasons to suspect this spending spree is unsupported by actual economic activity, and in a phenomenon of monetary inflation.
For example, today’s tsunami of spending raises questions when we consider there are still about five million fewer people working in the American economy than was the case in early 2020. That means fewer people being paid wages. Without monetary inflation, an economy with millions of fewer workers suggests there should be less spending.
Additionally, spending increases when the public suspects that inflation is going to increase. That is, if there is perception the value of money will decline, the demand for money will decline also. As Ludwig von Mises noted: “once public opinion is convinced … the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size.”
That means more spending. This phenomenon is already clear in home prices and grocery prices. The public may suspect rising prices are here to stay. Meanwhile, the Consumer Price Index—a very limited measure of goods-price inflation—is nonetheless near a 35-year high. That means now’s a good time to spend.
With 2020’s panic-induced saving subsiding, people are now wondering if their savings produce any returns. But ordinary savers are surely now remembering that the interest returns from savings right now are next to nothing. Thanks to the central bank’s ultra-low interest rate policy, we live in a yield-starved world. That’s OK for hedge funders who can participate in carry trades and other high-yield forms of investment. But for regular people they’re stuck with interest rates that don’t keep up with price inflation. So it makes more sense to spend dollars rather than save them.
So, Biden’s people are correct in a certain sense that people have “more money” and that “demand is up.” With federal spending hitting historic highs—and half of it is deficit spending that’s being monetized—we should expect people to have “more money.” This is just what we would expect in an inflationary environment. We should expect demand for everything (but money) to be up.
The question, however, is how much of this windfall will continue in real, inflation-adjusted terms. It’s too early to tell, although we can also see that inflation-adjusted median earnings collapsed 6.3 percent, year over year, during the second quarter of 2021. We can see that real GDP growth has dramatically slowed.
But at least as far as the third quarter is concerned, it’s fairly clear the US was—and likely still is—in the midst of an inflationary boom. But how long will it last?
Economy
There Are Still Over 14 Million Americans On Some Form Of Government Dole
… we remind readers of the gaping chasm between those still claiming some form of pandemic-related unemployment benefit and the record number of job openings in America currently…
Initial jobless claims hovered at post-COVID-lockdown lows but were disappointing at 373k – well above the 200k-ish norms of pre-COVID
Source: Bloomberg
Notably, California and Virginia ‘estimated’ their jobless claims last week and Pennsylvania continues to swing wildly from week to week…
But, while the picture is improving overall, we should still remember that there are over 14 million Americans still on some of government dole…
Source: Bloomberg
We do note that 460k Americans dropped off the pandemic emergency aid rolls…
Finally, we remind readers of the gaping chasm between those still claiming some form of pandemic-related unemployment benefit and the record number of job openings in America currently…
Source: Bloomberg
Tick-tock on those benefits.
Economy
The Fed in a Box Part 2: They Cannot End Quantitative Easing
If inflation doesn’t slow in the coming months, the Fed may be forced to step in.
- If the Fed tapers QE, it may reveal waning appetite for long-term treasuries
- The Treasury may have used its cash balance reserve to anchor inflation expectations
- If inflation persists, the Fed may have to increase rather than decrease QE
Note: By definition, inflation is an expansion of the money supply. In this article, inflation will be used interchangeably with rising prices (usually as a result of money supply expansion)
Introduction
When the economy was shut down in March 2020, the government responded with massive fiscal and monetary support. The fiscal stimulus totaled $4T+ in relief packages. All of this spending was paid for with debt issued by the Treasury. The Treasury mostly issued short-term debt. With rates being held at zero by the Fed, and strong demand for short-term debt, it made sense to quickly raise cash using Treasury Bills as interest-free loans.
The Fed monetary policy was two fold, slash short-term rates to zero and inject $1.5 trillion into the long-term debt treasury market. The effect was to bring down interest rates across the entire yield curve. After the initial debt binge, QE went on auto-pilot, with the central bank buying about $80B a month in long-term debt (plus another $40B in Mortgage debt). Over the last year, the Treasury has continued to issue long-term debt, averaging more than the $80B the Fed has been buying. This has caused long-term rates to rise.
All of this fiscal and monetary stimulus is not without cost. Historically this type of activity almost always leads to higher inflation. The Fed may have recently indicated it wants higher inflation, but this is not true. This stance simply provides cover for them to not act in the face of rising prices. To actually fight inflation, the Fed would have to increase short-term rates above the rate of inflation. Part 1 of this series went into detail about how US short-term debt has doubled from $2.5T to $4.5T. This makes even small changes in short-term rates an immediate risk to the federal government, not to mention the much higher rates needed in a true inflation fight.
In theory, the Fed could leave short-term rates at 0% while ending QE and even shrinking its balance sheet. This would push long-term rates up to combat inflation. In the short/medium term the Treasury can mathematically handle higher long-term rates because it takes time for the higher rates to work their way through long-term debt. See the chart below that shows how the last tightening cycle worked its way through the average interest rate across debt instrument. Specifically, look at Notes compared to Bills. The average weighted interest rate on Bills moved very quickly where the rate on Notes barely had time to increase before rates dropped again.
Source – Treasurydirect.gov
Although the Treasury could handle rising long-term rates (even if the economy and mortgage market cannot), the Fed has another problem. Rising long-term rates send an important message: rising inflation expectations. While inflation is first and foremost a result of monetary policy, higher inflation expectations quickly exacerbate the problem. This is why the Fed has been messaging they are OK with higher inflation and also why they have been pounding the table that inflation is transitory. They need to keep inflation expectations low! If inflation expectations were to rise, especially at this critical juncture, it would be game over for the Fed, as they would have to raise short-term rates (devastating the Treasury and economy) in order to save the dollar and squash inflation.
With the economy opening up in March of this year, things were getting very precarious as inflation was rapidly rising along with surging long-term rates. Remember that rising long-term rates indicate rising inflation expectations. This could cause transitory inflation to be much less transitory.
In summer 2020, the Treasury issued enough debt to build up a significant cash reserve. In response to rising long-term rates in Q1 2021, it appears the Treasury strategically used its cash reserves to slow down the issuance of long-term debt. With total short-term debt outstanding already so high, the cash balance gave the Treasury ammunition to decrease debt issuance just as a $1.9T stimulus bill was passed and inflation was set to explode higher. This would have been perfect timing to support the Feds narrative that inflation is transitory to keep expectations from snowballing out of control.
If inflation doesn’t slow in the coming months, the Fed may be forced to step in. With the Treasury poised to issue more debt, it can no longer rely on its one-time use of excess cash reserves. This will put more pressure on the Fed to clamp down long-term rates by increasing rather than decreasing QE. Yes, the Fed may decide to print more money (leading to higher prices) to fight rising inflation expectations (higher long-term interest rates).
Understanding recent fiscal and monetary maneuvers
Last year, when the pandemic hit, the US Government started spending trillions of dollars. Massive spending plans were approved in the name of stimulus and COVID relief. Because the government does not have much money on hand, and taxes cannot quickly be raised, the Treasury issued trillions in debt. The markets can easily absorb short-term US Treasury Bills, so when the Fed abruptly cut rates to 0%, the Treasury responded by issuing short-term debt to the tune of $2.4T from March to June 2020. See figure 1 below.
Source – Treasurydirect.gov
In tandem, the Fed bought up trillions of dollars in US Debt, but the Fed was buying on the long end of the curve while the Treasury was issuing debt on the short end. This caused long-term rates to collapse. The Fed purchased enough long-term debt to absorb more than a year’s worth of long-term debt issuance. The chart below shows how the month over month and cumulative change in the Feds balance sheet compared to the Treasury Debt Issuance of long-term notes and bonds.
Source – Treasurydirect.gov
This action by the Fed had a massive impact on long-term rates. The chart below shows the difference between the two bars above, specifically the difference in Fed Buying and Treasury issuance of long-term debt for each individual month since Jan 2020. These values are not cumulative. The right Y-Axis shows the month-end interest rate of the 10-year bond. Looking at this chart shows something extremely clear: When the Fed buying exceeds debt issuance, rates are flat or falling; however when long-term debt issuance surpasses the Fed’s buying, rates rise.
Source – Treasurydirect.gov
The impact of the Fed can first be seen as interest rates fell from 1.5% to .6% during the initial buying spree. After the initial burst, the Fed put QE on auto-pilot, buying “only” $80B a month in long-term Treasuries. However, because the Treasury was issuing more than $80B a month as depicted by the positive bars starting in June 2020, interest rates started rising.
This trend started to accelerate in November of 2020, as long-term debt issuance was outpacing Fed Buying by around $200B. Things really started to escalate in the first quarter of 2021 as Treasury Debt issuance surpassed Fed buying by $286B in March right as interest rates were crossing above 1.7%.
Then, suddenly, long-term debt issuance started falling in April and was almost even with Fed buying in May. This consequently led to a fall in long-term rates, which are now hovering back around 1.5%. How did this happen just as Biden was pushing through a $1.9 stimulus package? Unlike 2020, when short-term debt issuance was used to plug the gap, Figure 1 above shows that short-term debt issuance was actually turning negative (blue bars).
What gives?
One look at the Treasury Cash Balance sheet in the chart below tells almost the entire story. This was first highlighted by a SchiffGold article published June 16. The chart below shows a massive surge in cash reserves by the treasury last year. Since March of this year, the cash balance has plummeted by over $1T.
Source – Treasurydirect.gov
Inflation Expectations
Why such a massive and sudden drawdown in the cash balance? In truth, there could be lots of reasons, but it does seem extremely sudden. One would think the Treasury, led by Yellen, would be very deliberate and thoughtful about how to use up $1T+ in dry powder. For the past 3 months, the Fed has been shouting from the rooftops that inflation is transitory. At the June FOMC press conference, Powell stood up and explained how long-term inflation expectations remain well-anchored. A proxy for inflation expectations is long-term interest rates.
Had interest rates continued to rise similar to the recent trajectory (climbing from .8% in Nov to 1.7% in March), this would have been a difficult narrative to push. The Fed needs inflation expectations to remain in check or else inflation will be anything but transitory. Thus, the perfect time for the Treasury to pause issuance of long-term debt would be April-June 2021 just as the economy is re-opening and the Fed is forecasting inflation to be at its worst before coming back down.
While this is speculation, it would be a very strategic move from both Powell and Yellen. Regardless of the intention though, the problem is that the Treasury has now spent its large cash balance. It could return to the short-term debt market, but the outstanding balance is still sitting above $4T (see part 1). It needs to be converting that short-term debt to long-term debt while long-term interest rates are still low and the Fed is still buying. But the Fed is simply not buying enough at $80B to convert all that debt!
If inflation persists beyond a few months, then interest rates are going to rise in a hurry as the market demands higher rates. Adding fuel to the fire will be the Treasury debt issuance overwhelming the $80B Fed buying as it did from November to March.
Then what?
Who is absorbing the long-term debt to keep interest rates from returning to the upward trajectory from Aug 2020 – Mar 2021?
International creditors have had little appetite for US Debt lately. The chart below shows the total outstanding debt held by foreign governments. In the past 15 months, while the Treasury has issued over $4T in new debt, the net amount bought by foreign governments is close to zero.
Source – https://ticdata.treasury.gov/Publish/mfh.txt
To zoom into the exact amount of change since the massive debt issuance, see the chart below. In total, foreign creditors have absorbed $120 billion of $6T+ or less than 2% of total issuance!
Source – https://ticdata.treasury.gov/Publish/mfh.txt
How are rates going to stay low if the Fed keeps the treasury buying cap at $80B? The Treasury will have to issue more than $80B in long-term debt to continue funding all the massive spending. If inflation expectations stay low, maybe the market will have enough firepower to ingest some of the new debt, but not all of it. With the Fed planning to begin tapering at the end of the year, someone will need to fill the $80 billion void. This does not even take into account the possibility of shrinking the Fed balance sheet, which should be considered impossible at this point.
The chart of the international holders above brings to mind the image of the Wiley Coyote running off a cliff. With 10-year interest rates hovering near 1.5%, one could argue there is strong demand for long-term Treasury debt. Unfortunately, foreign creditors have turned off their debt purchases. It took decades for them to accumulate ~$7T in Treasury debt. The Fed alone has accumulated more than half that (~$4.5T) over the last decade. The Fed is making the market seem strong, but as shown above, there might be nothing but air if they were to exit the market. With a thumb on the scale, no one is getting an accurate reading of true demand for US long-term debt.
Source – Warner Brothers
What about short-term debt markets?
As highlighted several times, the demand for short-term debt seems to remain very strong. This makes sense as T-Bills mature in less than a year, so these investments are perceived as nearly risk-free. In fact, it could be argued that the recent Treasury Bill issuance hiatus (Figure 1 – blue bars turning negative) could be causing stress in the Reverse Repo market. The chart below shows the current Reverse Repo market. Based on past quarter-end data, it’s very possible that Reverse Repos could exceed $1.5T by this coming Wednesday, June 30, before coming back down.
Source – https://fred.stlouisfed.org/series/RRPONTSYD
Many articles have been written to explain this phenomenon, without providing exact clarity on what’s actually going on. The current understanding seems to be that the banks are awash with cash – so much cash, they are hitting the limits in terms of how much cash they can hold on balance overnight. This is cash that should be invested on behalf of money market funds. But with so much cash in the system, if it were to all be invested in short-term debt instruments, it could drive rates negative. To avoid negative rates, the Fed is lending banks assets on its balance sheet overnight in exchange for cash. It is critical to avoid negative rates to insure money market funds never experience a loss and result in breaking the buck.
Maybe this is a leap too far, but it seems another solution to the Fed reverse repurchase activity could be for the Treasury to issue more short-term debt. So, why has the Treasury been drawing down its cash balance and letting short-term debt mature when there seems to be strong demand in the market? The Treasury must recognize the risk of having too much debt in short-term instruments and is trying to lengthen the duration of its debt outstanding. Unfortunately, this abundance of cash in the repo market is in search of low-risk short-term debt so will not provide demand for long-term debt.
If this is the case, it has created quite the pickle for the Treasury. By issuing too much short-term debt, the Treasury is by default putting pressure on the Fed to not raise short-term interest rates. However, by issuing too much long-term debt, the Treasury is by default putting pressure on the Fed to maintain or even increase quantitative easing. To reiterate, this is why it is imperative the market believes inflation is transitory. The Treasury cannot stop issuing debt, which leaves the Fed unable to raise rates or taper QE without wreaking havoc in the bond market. Additionally, if the Fed has to fight inflation, then it’s not just the Treasury facing its Wiley Coyote moment, but the entire US economy.
Wrapping up
With the economy reopening, the Treasury deployed its cash balance at the most opportune time, unless of course inflation numbers continue to increase (which based on all the data, anecdotal evidence, and liquidity in the repo market seems like a strong possibility). Unfortunately for the Fed, the Treasury will have to begin re-issuing debt again. Will it lean towards short-term debt hoping the Fed keeps interest rates low, or long-term debt hoping the Fed will expand QE?
But Fed may be constrained either way because it has its own problem. Powell must be praying that inflation readings come in low AND job numbers disappoint. If both don’t occur, then tough questions will be asked to justify more stimulus. Yellen and Powell may be best buds, but simple coordination will not be enough. They will need magic and luck to keep the course steady heading into 2H 2021 and 2022.
If the Fed is lucky enough to get low inflation readings out of its rigged CPI, it may provide cover to begin tapering. Rising long-term rates won’t have the same compounding effect on inflation expectations in a “low” inflation environment. Unfortunately, long-term rates will not be tenable over the medium term as the government has to finance more and more debt. As the market this year has indicated, when issuance surpasses Fed buying, rates have gone up. So what happens to rates when the Fed leaves the market entirely? Presumably, they go up a lot. How high will the Fed let rates go before re-entering?
Just because something is inevitable (US Debt spiral) does not make it imminent; however, the next six months of data may shine a bright light on all the irresponsibility over the last 12 years if inflation proves not so transitory. Chances are, the only thing transitory will be “talking about talking about” tapering.
US Debt interactive charts and graphs can always be found on the Exploring Finance dashboard: https://exploringfinance.shinyapps.io/USDebt/
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