The Fed finds itself in a dirty hole

There’s never a good time for the U.S. government to hit its debt issuance cap — and spark speculation of a possible imminent default if Congress refuses to raise it.

Now, however, the timing is particularly inopportune for this fight. That’s partly because big foreign buyers have quietly scaled back their Treasury purchases over the past year, and that could accelerate if talk of a potential default heats up.

It’s also because liquidity has repeatedly disappeared from the Treasuries sector during times of stress in recent years, due to underlying vulnerabilities in the market structure. This could easily reoccur in the event of a debt ceiling shock, as these structural issues remain (woefully) unaddressed.

But the main reason to worry at the moment is that the financial system is at a crucial stage in the monetary cycle. After 15 years of accommodative monetary policy, during which the US Federal Reserve increased its balance sheet from $1 billion to $9 billion, the central bank is now trying to extract liquidity from the system, to the tune of about $1 billion. dollars per year.

This process is needed and long overdue. But it was always going to be difficult and dangerous. And if Congress spends the coming months convulsed by default threats — since the Treasury’s ability to fund itself apparently runs out in June — the risks of a market shock will skyrocket.

A recent report by US lobby group Better Markets describes the broader context well. This entity first rose to fame during the 2008 global financial crisis, when it became a thorn in the side of regulators on Wall Street and Washington because it loudly – ​​and correctly – complained. follies of excessive financial deregulation. Since then, he has continued to scrutinize the darker details of US regulations, complaining, again rightly, that the rules have recently been watered down.

However, in a striking sign of the times, it now has another target in its sights: the Fed. Most notably, he thinks the biggest danger to financial stability is not just the finer details of regulation, but loose monetary policy after the crisis. This left investors “strongly encouraged, if not forced, to [purchases of] riskier assets,” it “decoupled asset prices from risk and sparked a historic borrowing and debt frenzy,” says the Better Markets report. Thus, between 2008 and 2019, the amount of US debt held by the public increased by 500%, non-financial corporate debt increased by 90% and consumer credit, excluding mortgages, jumped by 30%.

Then, when the Fed doubled its balance sheet in 2020 amid the pandemic, those categories of debt grew an additional 30%, 15%, and 10% respectively. And the consequence of this explosive leverage is that the system today is very vulnerable to shocks as interest rates rise and liquidity declines – even before you factor in a cap line of the debt.

“The Fed is in many ways struggling with problems of its own making. And given the scale of the problems, it is very difficult to solve without some damage, “thunders the report. “While the Fed monitors and seeks to address risks to financial stability and the banking system, it simply hasn’t seen itself – or seen or seen itself – as a source potential for these risks.”

Fed officials themselves would dispute this, as they believe their accommodative monetary policies prevented an economic depression. They might also note that rising debt is not just a US problem. One of the most astonishing and often overlooked features of the post-crisis world is that global debt as a proportion of gross domestic product has risen from 195% to 257% between 2007 and 2020 (and about 170% in 2000) .

Moreover, Fed officials would also rightly point out that the central bank is not a direct cause of the fight against the debt ceiling. The blame here lies with political dysfunction in Congress and an insane set of Treasury borrowing rules.

But even granting these caveats, I agree with Better Markets’ central message that the central bank could and should have been much more proactive in recognizing (and addressing) the risks of its post-crisis policies, not least because it now leaves the Fed – and investors – in a bad hole.

In an ideal world, the least bad way out of the debacle would be for Congress to abolish debt ceiling rules and create a bipartisan plan to rein in borrowing; and for the Fed to publicly acknowledge that it was a mistake to keep money so cheap for so long, and therefore to normalize ever-increasing levels of debt.

Maybe it will happen. Last week, Sen. Joe Manchin floated some ideas on Social Security reform, suggesting there might be a path to a bipartisan agreement to avoid default. But if that doesn’t emerge, the coming months will bring rising market tensions and/or a scenario in which the Fed is forced to step in and buy Treasuries itself – again.

Investors and politicians would undoubtedly prefer the latter option. Indeed, many probably assume that it will happen. But that would again increase the threat of moral hazard and create even more problems in the long run. Either way, there are no easy solutions. American money chickens come home to roost.

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