personal views of a former fed trader

Fed Cannot Fight Today’s Inflation

Inflation is on the market’s mind, but the Fed isn’t worried because it thinks it has the the tools to tackle inflation. Raising the funds rate seemed to work in the 1980s, but there are reasons to think it may not work well today. The prior financial landscape was bank centered – raising the funds rate increased the marginal opportunity costs of banks, which discouraged credit creation and thus dampened economic activity. But we are moving into a world where most money is created through deficit spending, which is indifferent to interest rates. In addition, the large stock of high duration fixed income securities pose financial stability risks. Higher rates redistribute wealth between private debtors/lenders, but inflict net losses to investors in public debt as the sovereign does not react to changes in its wealth. These net losses cascade and compound through the financial system in ways that are difficult predict. In this post we further describe these two structural changes that constrain the Fed’s ability to fight today’s inflation.

12% inflation in the 1980s was no match for a 17% Funds rate

From Bank Printing to Government Printing

Banks have traditionally been the primary source of money creation, but that is changing. Typically a bank makes a loan, which results in the creation of bank deposits that are spent into the economy. When economic activity runs too hot the Fed would raise the opportunity costs of banks (Fed funds pre-Crisis, IOR post-Crisis), reducing their willingness to make loans and thus dampen economic activity. Capital markets lending activity is similarly tamped down via the ON RRP offering rate, which is the opportunity cost for non-bank investors.

Treasuries outstanding as a proxy for deficit spending.

But most new money created over the past year came not from banks but the Federal Government. Treasuries are a form of money in the modern financial system and they are essentially printed as payment to fund spending. Fed QE changes the composition of money rather than the quantity (fewer Treasuries more reserves assets/bank deposit liabilities – see here for walkthrough). Think of it as Uncle Sam issuing you $1000 in Treasuries as your stimulus payment, and then you selling that to the Fed for $1000 in bank deposits.

Annualized real personal income at all time highs because of government payments

The Government printed $3 trillion in helicopter money last year, including over a trillion to businesses (forgivable PPP loans – $780b and counting) and individuals (direct stimulus checks/extra unemployment). The trajectory of fiscal spending over the past few decades suggests this is an accelerating trend – there are discussions now to make stimulus payments recurring. Free money is a winning political platform. To the extent this is a structural change, the Government will become the dominant creator of money and driver of economic activity. This weakens the Fed’s influence on inflation, as the level and composition of fiscal spending is a political process that is indifferent to rates. In fact, higher inflation may even be a justification for higher stimulus payments. Raising rates would thus have a weaker impact on economic activity.

Treasury Losses Are Net Losses to the System

Raising rates also introduce significant financial stability concerns due to the enormous stock of fixed income investments, much originated in a historically low rate environment. Lenders and borrowers in private sector fixed income experience a wealth redistribution when interest rates rise. Fixed rate (floating rate) borrowers (lenders) receive a windfall at the expense of their lenders (borrowers). But total wealth is unchanged, as one person’s asset is another person’s liability. Nonetheless, this process can be disruptive as the winners may not behave in the same way as the losers did.

The U.S. has become highly financialized

However, losses on Treasury investors are not counterbalanced by gains elsewhere. This is because the Government is not budget constrained and does not care about its wealth. A stronger balance sheet does not change Government behavior – it will not tax less or spend more in response. Money thus essentially evaporates out of the financial system. [Note that hedging does not change the total loss to the system, but reallocates it from one counterparty to another.] These losses cascade throughout the system in unpredictable ways. For example, risk parity funds may be forced to sell equities to re-balance, in turn forcing margin calls on equity investors. In addition, the official sector essentially mandated all core financial institutions to hold Treasuries as safe assets, so Treasuries are embedded in big banks to dealers to GSEs. Losses from Treasuries would weigh on the most essential segments of the system.

It’s not clear how much losses the system can take, so any rate hikes would have to be very conservative. The Treasury market is simply too big to fail – significant losses would lead to systemic failures. A “reverse wealth effect” is probably not how the Fed wishes to fight inflation.

Rates Will Always Be Low, Asset Purchases Are Forever

Sophisticated old guard Fed insiders continue to think the Fed can just raise short-term rates to 4.5% like it once did. The Fed’s last foray into “normalization” reached 2.5% in December 2018, when imploding markets forced a rapid U-turn. It might take another December 2018 to get the message through. Higher rates today would have a limited effect on inflation but an outsized impact on financial stability.

2.5% was too much for the S&P 500

Control of inflation is moving out of hands of the monetary authorities and into hands of the fiscal authorities. Future inflation will largely be determined by the level of fiscal spending and taxation, which drains money out of the economy. The one thing the Fed can still do is protect the “moneyness” of Treasuries – that means lower rates and more asset purchases, forever. Just like the ECB and the BOJ. There is no normalization – we are firmly in a new paradigm.

13 Comments

  1. Harsha G.

    Excellent analysis!

  2. Effem

    The Fed had been vocal about pushing the government to do more fiscal spending. So they unwittingly abandoned their inflation mandate? Are they really that unsophisticated?

  3. Ivan

    I wanted to ask this question today at school, but forgot. Thank you for answering.

    The natural rate of interest is zero, and it’s here to stay.

  4. Oik

    You cannot “fight” inflation without a reversal in “wealth” … even modest rate rises would cause a deflationary recession.

  5. Float the basis

    Interesting article but pretty extreme. At what level of rates is this story relevant, as it hasn’t been in the last 0.75% sell off in US 10y?

    If fiscal spending does spur permanent inflation, under AIT the Fed will be behind the curve and need to hike further and faster. Will they hike faster than their ability to see its broader effects? Possibly. Either way we’ll likely see higher US rates before this “story after the story”.

    • Fed Guy

      Good points – rates did go up quite a bit and quickly with little impact on markets. I think rates can go higher – certainly don’t hear push back from Fedspeak.

      Overall I look at it like this: rates moving lower over the past few decades added more money into the system via collateral enrichment, and now the process is reversing but with a much higher stock of debt and lower coupons. The losses will not be linear. Investors are leveraged, and liquidity can be poor. As collateral evaporates something will break.

      There’s probably not a fixed rate level – depends on dynamic things like how quickly rates rise, how market is positioned, liquidity, perceived fundamentals etc. In December 2018 Fed’s dot plot suggested 2 rate hikes in 2019, but they actually ended up cutting. If 2.5% was too much back then, I imagine the threshold would be lower today since the stock of debt is higher. On-going big QE is taking duration out of market and making it more resilient though.

  6. TB

    In the simplest terms I believe the long term plan is to have money behave something like a electric utility connection to each household (i.e. it cannot be stored in any large quantity). Inflation – in the conventional sense – won’t matter because digital money will programmed to be ephemeral. Each household will receive their weekly quota depending on job/benefits/social credit score. Any semblance of financial independence from the authorities will be lost. Forever treasury issuance/QE is just the first step down this road.

    • Ancor

      Road to serfdom then

  7. FED up

    Hi FED GUY,
    Really interesting.
    I’ve been hearing all this “go on forever” talk for a while now, but I can’t help thinking – what’s the price? How come the FED / US can create money out of thin air, and there’s no cost to that? What’s the value of money in that case?
    What am I missing?
    Thanks!!

    • Fed Guy

      In a pure fiat system money is ultimately backed by confidence in the sovereign. The U.S. has a strong global reputation – most people today grew up in a world where the U.S. was a dominant, benevolent, and respected power. Many continue to believe the U.S. will manage its currency prudently. Should people began to question those assumptions, then they will move out of currency and into things like equities and real estate – tangible investments. Things like this usually happen slowly, then all at once.

  8. Tom

    I agree that purchases of Treasuries are here to stay forever, but do you think they’ll continue the purchases of MBS? There is a structural undersupply of SFH that is leading to price appreciation, i don’t see a real reason to continue support MBS prices further as skyrocketing housing prices will lead to skyrocketing rent increases that will further harm the lower income population that depend on affordable rent to live.
    The government isn’t going to expand rental assistance while the MBS purchases are still ongoing are they?

  9. Ancor

    So you are saying the Fed does not have the tools yo fulfill its charter (price stability one of their mandatory goals)

  10. Ancor

    Inflation reduces the value of the existing debt but increase the value of non funding liabilities…. So what are the constrains to ever expanding budget deficits? Currency devaluation, commodities inflation?

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