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Reprinted with permission•Mises Wire•Daniel Lacalle
The money supply (M2) has bounced to March 2023 levels and has been rising almost every month since October last year. Furthermore, US government deficit spending has more than offset the decline in the Federal Reserve balance sheet. While the Fed’s balance sheet has shrunk by $1.5 trillion from its peak, the US government deficit remains above $1.5 trillion per year.
The money supply (M2) in the United States has bounced above March 2023 levels, while deficit spending offsets any Fed balance sheet reduction.
It is no surprise to read that the Federal Reserve has kept rates unchanged. Mr. Powell indicated that there are no rate hikes on the horizon, which was received with relief by market participants, but he also cast doubt about the expectations of rate cuts. However, the single most surprising message came when the Federal Reserve chairman announced that they would delay the quantitative tightening process.
In its statement, the Fed explained that “beginning in June, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The Committee will maintain the monthly redemption cap on agency debt and agency mortgage-backed securities at $35 billion and will reinvest any principal payments in excess of this cap into Treasury securities.” The FOMC statement presents an otherwise optimistic economic outlook, which is at odds with this message. Why would the Fed need to slow down the pace of balance sheet reduction in a strong economy with solid unemployment, consumption, and growth figures?
The answer may lie in the Treasury yield curve. The FOMC issued this statement in a week in which the two-year Treasury yield touched the dangerous 5% level. On previous occasions, such a rise in government debt yields led to a significant market correction. However, the Fed is not as concerned about a market correction as it is about maintaining some calm in the bond market amidst an unsustainable increase in government deficit and public debt.
The Fed is choosing to keep the sovereign debt bubble alive as a priority over reducing inflation.
It is impossible to reduce inflation to the 2% target when the government deficit, which is printing new currency, remains out of control. It is even more difficult when the Federal Reserve delays normalization of the balance sheet, bringing the monthly redemptions to less than half the previous figure.
With this move, it is no surprise that the two-year yield fell to 4.8% and the ten-year slumped to 4.5% from 4.7% at the end of April.
The Federal Reserve is reluctant to admit two things: the Treasury’s debt supply is significantly higher than private sector demand, and the Fed is more concerned about a bond market meltdown than elevated inflation.
A bond market meltdown would be exceedingly dangerous for the Federal Reserve because it would arrive at a moment when the US and European bond indices have not recovered from the 2022 slump. Furthermore, a bond price collapse would trigger further problems at the U.S. regional banks, just as we learned that Republic Bank required a bailout and corporate profits in the banking sector dropped by 44% in the fourth quarter of 2023, according to Reuters.
If the two-year bond yield rises above 5% and the 10-year yield soars, we could see a dramatic correction in a market that continues to build elevated risks under the expectation that the Fed will bail everyone out.
A bond market slump would bring down the entire deck of cards in a complacent market.
The decision of the Fed comes when the global demand for Treasuries is under question. Foreign holdings of Treasuries have risen to an all-time high, but the figure is misleading. Demand has weakened relative to the supply of new bonds. In fact, an expected surge in new issuances by the Treasury creates a headache for the Federal Reserve. Borrowing will be significantly more expensive when public debt interest payments have reached $1 trillion, and investor demand remains robust but not enough to keep pace with an out-of-control deficit. China’s holdings of US Treasury bonds have fallen for two consecutive months to $775 billion, according to the US Department of the Treasury, and Japan’s weak yen may need a Bank of Japan intervention to sell US reserves, which means disposing of Treasury bonds.
If the Federal Reserve’s economic outlook was as solid as stated and the solvency of the public accounts was robust, they would not be announcing a drastic reduction in the path of normalization. They would have accelerated it, given the high and persistent inflation.
The message that the FOMC statement sends to the world is that the US public finances are completely uncontrolled and that there is not enough demand for the insane increase in supply of new government bonds.
When the Fed keeps rates on hold and delays balance sheet normalization, it achieves two negatives. The full negative impact of rate hikes falls on the shoulders of the private sector, families, and businesses, and the balance sheet management keeps the public debt bubble artificially inflated, leading to more persistent inflation.
In summary, the Fed’s decision could be seen as a dangerous way to keep the government’s misguided fiscal policy alive at the expense of making families and small businesses poorer with elevated inflation and higher-for-longer-rates. Powell tries to be prudent and rigorous about inflation when the government fuels the fire. Powell is like a fireman trying to stop a fire with a bucket of water, while the owner of the building, the government, throws gallons of gasoline over the ceiling.
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