Stuck between a Rock and a Hard Place: The Federal Reserve, the US Government, and Inflation

Today’s inflation numbers were the most severe we’ve seen in 30 years. Why is that concerning?

In 1979 when the annual inflation rate hit 11.3% the National Debt stood at $827b, about 31% of US 1979 GDP. Over the course of the next three years the Federal Reserve raised reserve requirements in a successful attempt to slow inflation. As a result interest rates rose to 20%. The yield on the 10-year US treasury went from 8.92% to a peak of 15.51%

Today the CPI for June was announced up 5.4% YoY, the highest single month increase since 1991. Today the US national debt stands at $27.7T, about 129% of US 2020 GDP. The yield on the 10-year treasury is 1.40%

A reasonable person might wonder: “Why is the US Government paying so much less to borrow in 2020 than they did in 1980? Their leverage ratios (debt when compared to asset base) are much worse . Any private company with a similar progression would surely have to pay MORE to borrow today and not less than they did before.”

This kind of response is understandable. However, the US Government is obviously no private company. It is the manager of the most valuable and trusted currency in the world: the US dollar. It has the power, through the Federal Reserve, to print as much of that currency as its heart desires. And that’s exactly what it is doing.

The basic process is as follows: The Federal Government spends more money on entitlements/defense/etc than it takes in from tax receipts. It issues debt to fund the deficit. The Federal Reserve “prints” money and purchases that debt.

This is not a novel phenomenon, but the scale at which it is now occurring is. At the end of 2019 the Federal Reserve held $2.3T of US Debt. Since then they have nearly doubled their stake to $5.2T. Over that same period the total US debt increased ~$5T. This means the Federal Reserve effectively financed more than half of all US Debt created in the past year.

This dynamic is also visible in the monthly treasury auction. The Federal Reserve is still (16 months into the ‘recovery’) buying $80B of Treasuries each month. This is frequently representing ~60% of total monthly Federal Debt issuances.

Interest Rates are determined via supply and demand. The more people who demand a debt issuance, the less interest the issuer is required to pay to find a buyer. This dynamic is visible in the US Treasury markets. Thanks to never ending Fed demand, the US government is actually paying less to borrow over 10 years today than it was when debt:GDP % was <100

Why is this a problem you might ask? It seems as though the US Government has been successfully monetizing its debt for decades without consequence. People worried about inflation in 08/09 and they were wrong. In fact the only thing we did wrong back then was worry TOO MUCH about inflation.

Maybe. Maybe there’s no reason to be concerned again. Maybe if inflation comes the Federal Reserve can just stop buying Treasuries, raise interest rates, and safely steer the economy away from the death spiral of inflation like they did in 1981 (mind you even in this positive scenario the Fed had to trigger a recession to beat inflation).

What’s different this time? The National Debt. As mentioned before it sits at $27.8T, about 129% of US GDP. Each year the US Fed Government spends about $300b servicing that gargantuan debt. This expenditure represents about 10% of US tax receipts.

As discussed before this reasonable interest payment is only made possible through the Fed’s ongoing support. What would happen if that support went away as part of a larger policy push to fight inflation?

The CBO estimates that for every 1% increase in federal borrowing costs, the cost of servicing the debt increases by ~$230b. If borrowing costs were to increase by just 3% (1.41% → 4.41% 10 yr) servicing the national debt would become the Federal Government’s single biggest expense

It’s truly very difficult to say exactly how high federal borrowing costs would rise were the Federal Reserve to end its debt subsidy. One thing is for certain: if rates were to rise in any meaningful way, major Government programs (Medicare, Medicaid, Defense) would be dramatically impacted.

The US Government is stuck between a rock and a hard place.

It can continue monetizing debt via Federal Reserve funded treasury purchases, but risk creeping ever closer to a middle class crunching inflation cycle.

Or it can try to head off inflation by tapering asset purchases and raising rates, a move that will trigger the need for Federal spending cuts across politically untouchable entitlement and defense spending.

What’s our best hope? That I, and other concerned citizens, are off base again and the inflation that some expect to materialize in the near future fails to appear just like the inflation we were worried about back in 08/09.

Hopefully that’s the case. But I remain very concerned that our Government is entering into a trap of its own making that it cannot escape, and that the middle and working classes will feel the brunt of the pain created.