The Fed finds itself in a nasty hole

There is never a good moment for the US government to hit its ceiling for debt issuance — and spark speculation about a potential looming default if Congress refuses to raise it.

Now, however, is particularly inopportune timing for this fight. That is partly because big foreign buyers have quietly trimmed their Treasury purchases in the last year, and this might accelerate if chatter about a possible default grows louder.

It is also because liquidity has repeatedly vanished from the Treasuries sector at times of stress in recent years, because of underlying vulnerabilities in the market structure. This could easily reoccur in a debt-ceiling shock, since these structural problems remain (lamentably) unaddressed.

But the biggest reason to worry about the timing 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 expanded its balance sheet from $1tn to $9tn, the central bank is now trying to suck liquidity out of the system, to the tune of about $1tn a year.

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

A recent report from the American lobby group Better Markets outlines the wider backdrop well. This entity first shot to fame during the 2008 global financial crisis when it became a thorn in the side of Wall Street and Washington regulators because it complained loudly — and correctly — about the follies of excessive financial deregulation. Since then, it has continued to scrutinise the more recondite details of US regulation, 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, it thinks that the biggest danger to financial stability is not just the finer details of regulation, but post-crisis loose monetary policy. This left investors “strongly incentivised, if not forced, into [purchases of] riskier assets”, it “decoupled asset prices from risk and ignited a historic borrowing and debt binge”, the Better Markets report argues. Thus, between 2008 and 2019 the amount of US debt held by the public rose 500 per cent, non-financial corporate debt increased 90 per cent and consumer credit, excluding mortgages, jumped 30 per cent.

Then, when the Fed doubled its balance sheet in 2020 in the midst of the pandemic, these categories of debt rose by another 30, 15 and 10 per cent respectively. And the consequence of this exploding leverage is that the system is today highly vulnerable to shocks as interest rates rise and liquidity declines — even before you factor in a debt-ceiling row.

“The Fed is in many ways fighting problems of its own creation. And considering the scale of the problems, it is very difficult to solve without some damage,” the report thunders. “Although the Fed monitors and seeks to address risks to financial stability and the banking system, it simply failed to see — or didn’t look or consider — itself as a potential source of those risks.”

Fed officials themselves would dispute this, since they believe that their loose monetary policies prevented an economic depression. They might also note that rising debt is not just an American problem. One of the most stunning and oft-ignored features of the post-crisis world is that global debt as a proportion of gross domestic product jumped from 195 to 257 per cent, between 2007 and 2020 (and from about 170 per cent in 2000.)

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

But even granting those caveats, I agree with the core message from Better Markets, namely that the central bank could and should have been far more proactive in acknowledging (and tackling) the risks of its post-crisis policies, not least because this now leaves the Fed — and investors — in a nasty hole.

In an ideal world, the least bad exit from the debacle would be for Congress to abolish the debt-ceiling rules and create a bipartisan plan to get borrowing under control; and for the Fed publicly to acknowledge that it was a mistake to keep money so cheap for so long, and thus normalise ever-rising levels of leverage.

Maybe that will occur. Last week senator Joe Manchin floated some ideas about social security reform, suggesting that there might be a path to a bipartisan deal to avoid default. But if this does not emerge, the coming months will deliver rising market stress, and/or a scenario in which the Fed is forced to step in and buy Treasuries itself — yet again.

Investors and politicians would undoubtedly prefer the latter option. Indeed, many probably assume it will occur. But that would again raise the threat of moral hazard and create even more trouble for the long term. Either way, there are no easy solutions. America’s monetary chickens are coming home to roost. 



Business Asia
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