If there’s one thing to understand about what’s going on in the political economy today, it is the fundamentals of debt. You do not need to be a bean counter or get too deep into the weeds to get a handle on things.
What you must understand is this. Debt – public and private – has grown to such massive extremes that it will never be repaid.
But it will be settled one way or another. Through default or inflation, or a combination thereof. Moreover, the impending debt reconciliation will be legendary.
In the meantime, as debt has grown, it has distorted prices. This is the reason why housing prices and stock prices make little sense. And this is also the reason why consumer prices continue to rise.
Federal debt recently eclipsed $35 trillion. In practice, the Treasury is responsible for the abundance of debt that has been issued. However, the Treasury is merely funding the deficits dictated by politicians in Washington who are beholden to the vast cadre of special interests.
Defense spending. Green energy bills. Farm subsidies. Pork projects. Social welfare programs. Foreign meddling. The endless collection of agencies and agency jobs, where staff show up every day and do fake work. No boondoggle’s too big or too foolish for Washington to fund.
The ability for the Treasury to finance deficits would have stalled out long ago had it not been for the system of debt-based paper money that makes the limitless issuances of dollars possible. Of course, for every dollar of new debt that is issued there must be a lender. In the U.S., the lender of last resort is the Federal Reserve.
What’s going on at the Fed…
Maybe, Maybe Not
The Federal Open Market Committee (FOMC) met this week to contrive monetary policy and price fix the rate of interest. The focus from Wall Street was almost exclusively on interest rates. Namely, would the Fed cut the federal funds rate now or in September?
On Wednesday, following the meeting, the Fed left the federal funds rate unchanged at 5.5 percent. This was expected. But there were hints that rate cuts would maybe arrive in September. Here’s language from the FOMC statement, which is unchanged from the June meeting:
“In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
Will the Fed gain greater confidence inflation is dissipating before its September meeting?
Probably not. Thus, Wall Street will likely have to wait until November for the long-desired rate cuts.
When the Fed finally does cut rates, it will be for the first time since March 16, 2020 – when it took the federal funds rate down to near zero during the early days of coronavirus madness.
Still, the slight prospect of a rate cut in September was good enough for Wall Street. Traders celebrated the news by boosting the indexes. On Wednesday, the S&P 500 jumped 85 points and the NASDAQ increased 451 points. On Thursday, nearly all of these increases were given back.
As we see it, rate cut optimism is misplaced. Consumer price inflation is still well above the Fed’s arbitrary 2 percent target.
Balance Sheet Bonkers
The latest PCE price index is at 2.5 percent and the latest CPI reading is at 3.0 percent. So, the Fed still has some work to do to bring inflation down. Holding the federal funds rate at 5.5 percent for an extended period may ultimately do the job. Cutting too soon would risk another bout of rising inflation.
Nonetheless, rate cuts are needed to help bailout banks from all the underwater bonds they purchased in 2020 and 2021. They’re also needed to help the Treasury finance the remaining $1.3 trillion in borrowing it estimates it will need to make it through the end of the year.
Yet while everyone was almost exclusively focused on the Fed’s intentions to cut interest rates this week, they were ignoring the more important story. The Fed’s balance sheet, and how bonkers it remains.
If you recall, before the great financial crisis and the advent of quantitative easing (QE) in 2008, the Fed’s balance sheet was at about $800 billion. This was about 6 percent of GDP.
Then, between 2008 and 2014 the Fed jumped its balance sheet up to $4.5 trillion. Then, during the coronavirus panic, it ballooned its balance sheet up to $8.9 trillion by 2022.
The assets the Fed holds on its balance sheet generally consist of Treasuries, mortgage-backed securities, and some corporate bonds. Where the Fed gets the credit to buy these debt instruments is a sort of chimera. In short, it creates the credit out of thin air.
Since early-2022, the Fed has contracted its balance sheet by $1.6 trillion to just under $7.3 trillion. However, at this level it still amounts to 26 percent of GDP. This, in addition to runaway deficit spending, is why consumer prices will never return to pre-pandemic levels.
Dollar Debasement Ad Infinitum
Attached to this week’s FOMC statement was the customary implementation note. This implementation note is largely ignored.
Per the note, monthly balance sheet reduction of Treasuries is limited to $25 billion and monthly reduction of mortgage-backed securities is limited to $35 billion. Prior to May 2, Treasury holdings were reduced by $60 billion per month.
This tapering of the rate of balance sheet reduction means total assets held by the Fed will never return anywhere close to what they were in 2019. In short, the inflation of the money supply that occurred between 2020 and 2022 is permanent.
Kevin Warsh, a former Federal Reserve Board member, recently shared his opinions in a Wall Street Journal article, where he said:
“The Fed shrank its balance sheet in the past few quarters, down 7 percentage points from its peak as a share of GDP. M2 is down about 3%. Lo and behold: less money printing, less inflation.
“Price stability would be more easily achieved if the Fed continues to shrink its holdings. But Fed leaders have strongly signaled the opposite: that its asset holdings are approaching steady state. They argue that the fall in inflation can be traced to lower wage increases in a softer job market. In my view, irresponsible government spending and excessive money printing are largely to blame for triggering inflation in the first place.
“Had the Fed recognized the inflation problem sooner, it wouldn’t have been forced to raise rates so high. Had the Fed’s asset holdings stayed smaller or shrunk faster, inflation wouldn’t have risen so high. Hardworking Americans wouldn’t now be suffering the twin indignities of high prices and higher credit costs.”
Nothing Mr. Warsh said should be a revelation or controversial. That these criticisms are coming from a Fed alumnus is uncommon.
In closing, the Fed continues to act in the interest of the privately-owned banks it serves while sacrificing American workers, savers, and retirees. So regardless of if the Fed cuts rates in September or not, it already ended its inflation fight several months ago when it began tapering the rate of its balance sheet reduction.
Prices for goods and services have been permanently distorted higher, as policies of dollar debasement continue ad infinitum.
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Sincerely,
MN Gordon
for Economic Prism
Return from Dollar Debasement Ad Infinitum to Economic Prism
