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Federal Reserve To Maintain Path, But What Of Growing Federal Deficits?

by: John M. Mason

Federal Reserve officials, at the latest meeting of the FOMC, voted to "keep on, keeping on," maintaining the current direction of policy.

Things are changing, however, as the future now includes massive increases in government deficits with government debt loads approaching historical levels versus GDP.

The growth in federal debt outstanding might not only impact the Fed's efforts to reduce its balance sheet, but might also impact the Fed's ability to contain inflation.

The Federal Reserve is keeping to its plan to continue to raise its policy rate of interest this year, opting for a “steady as she goes” approach.

That means that it plans to raise its policy rate two more times this year… with the possibility that it might increase the rate a third time… depending upon the data.

Following the first path would bring the policy range for the Federal Funds rate up to 2.00 percent to 2.25 percent by the end of the year. If a third increase took place, we would have a 2.25 percent to 2.50 percent range by year-end.

The major point of concern for Fed officials seems to be the rate of inflation. There were no signs of concern in the FOMC statement about economic growth… or, unemployment.

Discussion seemed to center on the fact that the “on a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent.” The Fed’s target for inflation is 2 percent.

The one change noted in the Fed’s release is that annual inflation “is expected to run near the committee’s symmetric 2 percent objective over the medium term.”

The new wording included the term “symmetric.” It seems that by using this term, Fed officials are indicating that they would be comfortable with the rate of inflation exceeding the 2 percent target for a time and would not attempt to immediately act to bring the inflation rate down if the 2 percent goal were exceeded for a reasonably short period of time.

Can Federal Reserve officials stay on this plan?

Over the past ten years or so, the Federal Reserve has really faced exceedingly calm financial markets… supported, to a great deal, by its own activities.

But, the past ten years or so saw a period of time when the economic policies of the Federal government were very placid. That is, fiscal deficits were reasonably small and declining, and most of the weight of attempting to stimulate the economy fell on the shoulders of the monetary authorities.

Things have changed and we are just starting to see the consequences of the change.

Daniel Kruger and Ben Leubsdorf write in the Wall Street Journal:

“The Treasury Department is slowly ramping up its debt auctions to meet the federal government’s growing need for borrowed money.”

“Changes will result in $27 billion of new issuance over the coming quarter, the department said, driven by the Federal Reserve’s balance-sheet policies as well as the fiscal outlook.”

This is just the start. Around the middle of April, William Galston writes in the Wall Street Journal that the Congressional Budget Office issued its outlook for the next 10 years.

“Over the next decade, the annual federal deficit averages $1.2 trillion. It rises from 3.5 percent of gross domestic product in 2017 to 5.1 percent in 2027. The national debt, which is driven by annual deficits, rises from $15.7 trillion to $28.7 trillion over the same period, and surges from 78.0 percent to 96.2 percent as a share of GDP—the highest mark since just after World War II.”

And Mr. Galston argues that this is just a very conservative estimate. “The CBO estimates that if current policy continues—rather than current law—the cumulative deficit will rise a further $2.6 trillion over the next decade, to a staggering $15 trillion. This would push the national debt to 105 percent of GDP, a level exceeded only once in our history.”

How will this impact the actions of the Federal Reserve?

Well, as the Treasury Department admitted in its estimate of the “new issuance” of government debt over the next quarter, that some of the increase will come because the Federal Reserve is in a program to reduce the size of its securities portfolio.

As of April 25, 2018, the Fed has reduced its holdings of US Treasury securities by over $52 billion since the portfolio reductions began in October 2017. The Fed is allowing Treasury securities in its portfolio to run off at maturity without being replaced.

For the second quarter of 2018, the Fed’s original plan is to allow a further $54 billion to run off followed by another $72 billion in the third quarter and by $90 billion in the fourth quarter.

This would, hypothetically, put a further $216 billion of US Treasury securities back in the bond market.

Given the current deficit projections, one could argue that the Fed might be under a lot of pressure to back off from reducing the size of its securities portfolio because of all the US Treasuries that are entering the marketplace over the next eight months… and more.

But, then how does the new debt get financed?

Well, the commercial banks could help out here. Over the three periods of quantitative easing, the Federal Reserve created a lot of excess reserves for the banking system. As of April 25, 2018, there are about $2 trillion in excess reserves in commercial banks.

Still, this would be just a small amount of the projected $13 trillion increase in the Treasury’s outstanding debt over the next 10 years. How is the Treasury going to finance an 83 percent increase in it total debt obligations. And, this is only the amount resulting from the “conservative” estimates.

Maybe the real question should be “how much of this increase in the debt will the Federal Reserve absorb over the next 10 years?” not “how far can the Fed’s securities portfolio be reduced?”

And, if the Fed ends up financing a part of this increase in the government’s debt, how will this impact inflation? If inflation is going to be impacted, then inflationary expectations will rise and this will cause bond yields to rise. Then, how much will inflationary expectations increase?

If we move into such a picture, however, can Federal Reserve officials continue to control interest rates through its “forward guidance”?

Jon Sindreu argues very strongly in the Wall Street Journal that the Federal Reserve has been very successful in recent times in managing interest rates through “meticulous messaging” and “Why Central Banks' Power Over Markets Is Here To Stay.” He thinks it can continue to do so.

But, this is another story for another day.

The story for today is that the calm times for the Fed may be over as it faces the reality of massive increases in government debt over the next ten years. The conduct of monetary policy cannot remain as it has for the past ten years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.