The Dangers of the Fed Aiding Fiscal Policy
Anyone seeking clarity on current events is confronted with two seemingly irreconcilable pictures. The media portrays a massively costly war against the coronavirus in which victory remains elusive, coupled with the prospect of a disruptive, disputed election. Counting people who not working but collecting Covid-related benefits, unemployment approximates 30 percent. Entire sectors of the economy are shut down. The image reflected by the bond market, however, is an untroubled economy with no hint of impending political upheavals.
Calmness reigns in the market for government securities. Since the beginning of April, the ICE BofA US Treasury Index’s yield has remained within a 0.27- percentage-point range. The range was 0.96 percentage points in the comparable 2019 period.
Rates have held steady despite voracious demand for capital. Investment-grade corporate bond new-issue volume has already set an all-time record in 2020, with four months still to go. Corporations’ appetite for debt does not arise from core capital goods investment. Even excluding airlines those expenditures are 3% below pre-Covid levels. Instead, companies are managing their capital structures, building bigger liquidity cushions, and insuring against rising rates.
The speculative-grade segment’s risk premium is closely correlated with a credit availability indicator drawn from the Federal Reserve’s senior loan officer survey. Currently, 71 percent of banks are tightening the standards for medium and large companies to qualify for loans. Zero percent are easing standards, for a difference of 71 points. In past periods in which the difference exceeded 60 points, speculative-grade bond investors never accepted a yield premium over Treasuries of less than 16 percentage points. The current differential is 5 percentage points.
The only hint of stirring beneath the tranquil financial surface is the gold price. Over the past year the yellow metal has soared by 30 percent against all of the harder currencies, except for a rise of only 20 percent versus the Swiss franc. The surge to $2,000 an ounce could signal underlying fears of institutional instability in the U.S., an inflationary spike, dollar devaluation, and a resulting jump in interest rates. If that is the message, however, financial markets are ignoring it.
True, the yield on Treasury Inflation-Protected Securities (TIPS) is at an unprecedented low, close to minus 1%. This means investors are willing to pay about 1% a year for insurance against inflation, as measured rather imperfectly by the Consumer Price Index, while paying taxes on the nominal returns. Even this historical bespeaks investor complacency, however, if the danger from debts and deficits is as grave as many academics and commentators contend.
The market’s indifference may rest on a tenuous assumption about the velocity of money, reflecting decreased consumption and investment, not only in the U.S. but globally. Consumer prices can hold steady if a large money supply increase is offset by a drastic decline in the rate at which money changes hands. This explains why inflation did not surge after the Fed flooded the system to combat the 2008-2009 Great Recession, defying many economists’ warnings. Then as now, frightened consumers started saving more and spending less, causing transaction volume to plummet. Currently, expectations of a continuation of that behavior are holding down borrowing for investment (rather than capital structure management).
History-conscious investors, though, should be looking back even further than the last decade. Monetary velocity also declined during World War II, despite massive Fed purchases of government bonds. That kept inflation in check, although the period’s inflation numbers should not be taken at face value, since price controls were in place.
The Fed explicitly acknowledged that bond buying was necessary to finance World War II and prevent the US from defaulting on its debt. However, by 1951, with both the US and the world recovering from the global conflict, the Fed worried that continuing wartime policies would prove inflationary. President Truman reluctantly succumbed to the Fed’s demand to end the policy of keeping interest rates artificially low and buying the government’s bonds.
Currently, the market may be pinning its hopes on today’s Federal Open Market Committee (FOMC) members having the wisdom—and the requisite political support—to emulate their predecessors. Terminating the current bond purchasing program when the coronavirus crisis ends could initiate a period of price stability comparable to the 1950s.
This happy ending is not assured, however. The Fed minutes released on August 19 suggest that FOMC members have grown more apprehensive regarding the economic outlook. They consequently appear inclined to prolong their present, extraordinary support of the credit markets and, worrisomely, to stray further into fiscal stimulus.
During World War II the Fed was explicitly deemed an agency of the Treasury. By contrast, the present Fed does not profess to be carrying out fiscal policy. No other term, however, correctly describes the Fed’s purchase of $451 million of bonds issued by New York City’s beleaguered Metropolitan Transit Authority, subsidizing it to the tune of 0.85 percentage points below the private market bids. Given the central bankers’ less than sterling performance in their official role of managing monetary policy, it is dismaying that fiscal policy powers have been allowed to shift from Congress to the Fed.
Were it not for the monetary watchdogs’ own acknowledgement of their limited understanding of even the financial sector of the economy, we could be more confident that they will avoid stoking inflation by waiting too long. The following, blunt quotes are reminders, however, that no such confidence is warranted.
On January 10, 2008, Ben Bernanke stated, “The Federal Reserve is not currently forecasting a recession.” The National Bureau of Economic Research subsequently determined that the 18-month-long Great Recession was already underway on that date, yet six months later Bernanke declared, “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” In 2010 Janet Yellen confessed, “For my own part, I did not see and did not appreciate what the risks were with securitization, the credit ratings agencies, the shadow banking system, the S.I.V.’s. I didn’t see any of that coming until it happened.”
One prediction investors can take to the bank is that the Fed will have difficulty holding the line on inflation if the U.S. defeats the virus, market sentiment turns sharply for the better, the velocity of money consequently rebounds to normal levels, and the bond-purchasing policy continues. The Fed could also fail If the virus remains unconquered in the U.S. but gets eradicated in the rest of the world, producing a global increase in monetary velocity. Judging by the U.S. fixed income market data summarized above, investors are disregarding these potential outcomes.
Likewise, investors are paying no heed to the graver implications of the Fed conducting fiscal policy. It is not a matter of the central bank being capable of overriding a rise in confidence and keeping interest rates depressed. Congress allocated $75 billion of equity to the Fed under its emergency lending programs. The Fed can lever up at a 10:1 ratio to amass $750 billion of buying power. While that number pales next to the $45 trillion U.S. fixed income market, concern about the transfer of fiscal authority to the Fed is well justified. It represents an unacknowledged blurring of the traditional separation of powers that coincides with speculation about institutional uncertainties in the upcoming election.