CPI: The Fed has 21 trillion reasons to fight high inflation
Anyone who doubts the Federal Reserve is against accelerating inflation need only consider the size of the US Treasury market for reassurance.
The US consumer price index jumped 5% in May from the previous year, while the core CPI climbed 3.8%, the largest increase since 1992. Both measures have also exceeded month-to-month estimates, suggesting that the pressures on the world’s largest economy are not just due to so-called base effects. While it is still too early to say whether Fed officials are right or wrong that this increase is largely transient, the numbers explain why the central bank will likely move forward quickly in discussing how best to cut back on purchases of gas. ‘active at its meeting next week. .
While the Fed’s dual tenure focuses on maximum employment and stable prices, there is no doubt that monetary policy also plays a central role in allowing the US government to run persistent budget deficits. The Treasury market is now $ 21.4 trillion, down from just $ 2.9 trillion two decades ago. Still, you’d be hard pressed to find an investor concerned about rising national debt, as the average yield the Treasury pays on its interest-bearing securities has never been lower and real inflation-adjusted yields remain. deeply negative.
In a Bank for International Settlements work document published last month, Ricardo Reis, professor at the London School of Economics, outlined the implications of real interest rates (r) which are consistently lower than the growth rate of an economy (g), which in turn is less than the marginal product of capital. (m). This defines the American situation. His main conclusion: “The government can run a deficit forever. “
The first three months of 2021 raised doubts about this type of balance that continues in the United States as the Fed deliberately stayed off the inflation curve as elected officials increased fiscal stimuli. The benchmark 10-year Treasury yield jumped to 1.74% on March 31 from 0.91% at the start of the year in what was the worst quarter for US debt since 1980. The real yield to 10 years reached -0.54% in March, against -1.12% in January. While these levels are still low by any historical measure, the trajectory seemed clear and bond vigilantes seemed in control. As Reis puts it: “If the net spending is too high, the price of debt will be zero, because the private sector refuses to own this Ponzi scheme. “
However, the 10-year rate fell back below 1.5%, the real rate to -0.87%. Using Reis’ words, the latest move shows that the “bubble premium” for US debt remains firmly in place. He supports the Secretary of the Treasury Janet Yellen’s opinion that President Joe Biden should push forward his $ 4 trillion spending plans even if they lead to inflation that lasts until 2022. She added that Fed officials have the tools to deal with any sustained increase in price pressures.
The idea that the Fed will step in if necessary is crucial, as Reis’ research found that the idea of ”inflating debt” doesn’t really work because investors will demand a higher premium for holding government debt. This, in turn, limits expenses and ends up being a doomed proposition:
“To ease the debt burden of the budgetary authority, the best course of action for monetary policy in this economy is to stabilize inflation as much as possible. This has a footprint on the government budget, as it permanently lowers the inflation risk premiums that must be paid on the debt, thus creating fiscal capacity. Price stability generates fiscal resources, while a shift to monetary instability can trigger a rise in r and trigger a sovereign debt crisis.
To be clear, there is no reason to expect a debt crisis in the United States or other major developed economies. And academic work may tend to ignore some of the structural forces that keep Treasury yields in check: demographics creating an insatiable demand for fixed income securities, foreign investors enjoying higher currency hedged returns, and regulations that encourage banks to hold more US government debt. , to only cite a few.
Yet Reis’ report serves as a useful reminder that despite all the talk about inflation and interest rates being too low for too long, this environment has also allowed for unprecedented government deficits and monetary policy measures with relatively few consequences. That’s why Yellen used the term “lightly” in his comments last weekend. “If we ended up with a slightly higher interest rate environment, it would actually be a plus for the company and the Fed’s point of view,” she told Bloomberg News’ Saleha Mohsin. .
It is true that the central bank would like to move away from the zero mark. But fiscal reality suggests he can’t stray too far from it without risking the delicate balance. To get a sense of where the market is starting to weaken, consider that 10-year real yields peaked at 1.17% at the end of 2018, higher than any point in the past decade. . Yields collapsed the following year as US growth slowed and the Fed cut interest rates. Experience so far this year suggests that 2.5% is something of a soft cap on the nominal yield of long-term bonds.
With Treasury yields falling again, the Fed probably has enough cover to talk about cutting its bond purchases. It is therefore in a better position to react later this year if the explosion in inflation turns out not to be so transitory. President Jerome Powell must distinguish between providing plenty of housing and proving that the central bank still has control over price growth and interest rates. Bond traders seem to believe in him and his colleagues for now – giving America the green light for deficits forever.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
To contact the editor responsible for this story:
Daniel Niemi to [email protected]