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.
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.
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.
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.
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.
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.