Fed Starts Moving Away from U.S. Debt

On Wednesday, the Federal Reserve announced that it has begun tapering its monetary stimulus. This is one month earlier than what members of the Federal Open Market Committee had stated previously. The tapering is also more aggressive than expected, which tells us that the Fed has good reasons to be quite worried about the near to mid-term future of the U.S. economy.

Before I explain what the reasons are for those worries, let us take a look at the announcement itself. The November 3 FOMC statement started with the expectable formalities:

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With inflation having run persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent.

Again, this is mostly sausage filling. Currently, inflation is significantly higher than two percent, and still trending upward. Next week the Bureau of Labor Statistics will release October numbers for the Producer and Consumer Price Indexes, likely showing yet more inflation. The FOMC refers to its inflation target simply because it is one of their policy goals. However, they also took the opportunity to use this as a reference point, to anticipate the pain that some might feel as they move deeper into their announcement. Hence, explains the FOMC:

The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved. The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.

In other words, the Committee is trying to ease fears of interest rates rising as a result of their drawdown of Treasury debt purchases. Here is why:

  • When you tighten monetary policy, theoretically the supply of liquidity in the economy falls relative demand, causing the price of liquidity to rise;
  • The price of liquidity is also known as the interest rate; the mechanics that causes the interest rate to rise are to be found on the sovereign-debt market, where a reduction in demand for bonds causes prices of bonds to fall, which automatically raises the interest rate;*
  • When the Fed reduces its purchases of U.S. debt and interest rates start rising, the Treasury will have to spend more just to maintain the debt it has.

What is the result of that? Congress must allocate more money to paying interest on its debt, and with the Fed drawing down its Treasury purchases there will be less liquidity in the market. This will force Congress to abandon its current, open-ended fiscal policy and instead pay more attention to what it spends money on, and how it pays for that spending.

In other words, the FOMC’s mentioning of the federal funds rate is a political statement, meant to neutralize criticism that its tapering will force fiscal policy in a more conservative direction.

With that qualification in place, the Committee gets to the meat of its announcement:

In light of the substantial further progress the economy has made toward the Committee’s goals since last December, the Committee decided to begin reducing the monthly pace of its net asset purchases by $10 billion for Treasury securities and $5 billion for agency mortgage-backed securities. Beginning later this month, the Committee will increase its holdings of Treasury securities by at least $70 billion per month and of agency mortgage‑backed securities by at least $35 billion per month. Beginning in December, the Committee will increase its holdings of Treasury securities by at least $60 billion per month and of agency mortgage-backed securities by at least $30 billion per month.

And now for the big one:

The Committee judges that similar reductions in the pace of net asset purchases will likely be appropriate each month, but it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook.

Plainly: unless something really serious happens, they will continue their drawdown until they wrap it up in May. The tapering is now their default monetary policy.

The policy shift that was originally planned for December happened in November for three reasons.

The first is to be found in the scenario I outlined yesterday for what a fiscal crisis in America would actually look like. They know this is a real possibility, and it is likely that the Democrats’ plans for another round of enormous, deficit-funded spending – including major new entitlement programs that would add permanent deficit-funded spending to the federal budget – has gotten the Federal Reserve so worried that they felt it necessary to take action as soon as they possibly could. The FOMC announcement coincided conspicuously with plans in Congress to vote on massive spending bills.

In other words, this is the Fed’s payback for radicals in Congress demanding that the President replace Jerome Powell as Fed Chairman with someone who is sympathetic to, perhaps even an open proponent of Modern Monetary Theory. By starting its debt-purchase rollback just before the radical left’s big spending bills were up for a vote, the FOMC raised the price for those bills to a point where they may now be unpalatable even to mainstream Democrat legislators.

The FOMC would do this not because it is particularly protective of Jerome Powell’s job, but because they are genuinely worried about the radical fiscal agenda sending America rocketing into a fiscal crisis. In this sense, the Fed has taken responsibility for the country; as I noted recently, the Federal Reserve in general, and its chairman in particular, represent the last hope for America as a first-world, prosperous nation. I reinforced this point in yesterday’s article about what a fiscal crisis would actually look like.

If the first reason for the Fed to rocket-launch its tapering is related to fiscal policy, the second rests on a more classical monetary policy motive. Inflation is here and it is not going away, with third-quarter GDP numbers showing inflation close to five percent. And let’s not forget that the GDP-based inflation measurement is more conservative than the more widely used Consumer Price Index, the October numbers of which the Bureau of Labor Statistics will publish next week.

It is entirely possible, even likely, that the Fed, having a preview of those numbers, got so scared of where inflation is heading that they decided it was reason enough to move faster with their rollback of Treasury purchases. If so, we should expect a bombshell or two on Tuesday and Wednesday when PPI and CPI numbers are released.

The third reason for the Fed’s ramp-up is likely anticipatory: they know that as more adverse economic data is released, there will be shock reactions on key markets. Bad inflation numbers tend to drive up interest rates; if investors and analysts connect the inflation numbers to the Fed’s accommodating monetary policy, a delay in the tapering, and a moderate tapering when it eventually begins, will only add fuel to the concerns that drive up interest rates. Therefore, if you are going to shift from a policy of monetary accommodation to a policy of monetary tightening, it is wiser to do it slowly and gradually than to do it rapidly and risk interest-rate shocks.

With all that said, there is an oddity embedded in all this: the FOMC wants to tighten money supply while keeping interest rates unchanged. This is a contradiction in terms: the Fed can either control money supply or interest rates, but not both. All the members of the FOMC know this, and they know that analysts will see it as well, which makes their stated contradictory ambition even more curious. The superficial motive, to ease criticism from the radical left, is only a small part of the story; the deeper motive is embedded in the following sentence, which concludes the FOMC’s announcement paragraph:

The Federal Reserve’s ongoing purchases and holdings of securities will continue to foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses.

In short: the Fed is going to use indirect measures to ease the market reactions to its policy shift. By definition, it cannot do this without maintaining an expansionary monetary policy, but if that policy runs through other channels than deficit monetization, it will supposedly have less adverse effects on interest rates.

If this sounds cryptic, don’t be alarmed. I will discuss it in a lot more detail after the weekend.


*) The exact reason for this is that the Treasury security is a fixed-income asset: it pays $X per year. If the yield is $1 and you buy it for $50, you get two percent return on your investment; if you buy it for $100, you get one percent. When demand declines, sellers have to lower the price to unload their securities, hence the rise in interest rates.

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