“There is a thin line that separates laughter and pain, comedy and tragedy, humor and hurt.” - Erma Bombeck
There seemingly has been a lot of discussion as of late in financial media around Federal Reserve “independence” from the government. I have no clue why this is even a debate. The Fed, in my opinion, can’t possibly be independent with $22 trillion in federal debt.
Let’s revisit history first. The Federal Reserve was created in 1913 by Congress to, first and foremost, mitigate the potential for bank runs and a panic like what was seen in 1907. Stability has always been the key underlying raison d’etre for the central bank, and relative to the environment before its creation, the US was a far more volatile economic system to operate in. In 1977, Congress formally mandated that the Fed maximize employment and keep prices steady (largely through some form of “predictable” inflation).
The Fed is considered “independent” of the government in the sense that the central bank does not need permission by the President or Congress to do what it does. The Fed can raise or lower rates as its governors see fit. They get no funding from Congress, and Governors are appointed for 14-year terms purposely so as not to coincide with government term limits.
All this is great for the independence of the Fed structurally. The problem is there is absolutely no way the Fed can achieve its dual mandate of maximum unemployment and stable prices when federal debt as a percentage of GDP is over 100%.
And, if you haven’t been keeping track, debt is over $22 trillion.
The government employs a LOT of people, with some estimates suggesting over 10 million between full-timers and contractors. If rates rise significantly, with debt as high as it is, how exactly could the government pay for these people when interest costs to roll over that federal debt would rise alongside? The government couldn’t possibly tax us enough to cover the national debt (see debt per taxpayer above).
It’s simple – the Fed can’t possibly raise rates to any meaningful degree and be “independent” when government debt is this high because raising rates increases debt servicing costs, increases layoffs of federal workers (including those in the defense industry and army), increases unemployment, increases deflationary pressure, etc. Raising rates to a meaningful degree under the deflationary pressure of over $22 trillion in federal debt (TLT) would actually cause immediate violations in its dual mandate. This is probably why large-cap stocks (SPY) keep working - because lower rates allow for buybacks, financial engineering, and an endless supply of cheap capital because the government needs it too.
Debt then is the real link – the real dependence between the Fed and the government. The Fed’s mandates have allowed the debt to GDP ratio to rise the way it has since the dual mandate came into play in the late 1970s. So, please don’t tell me the Fed is independent. They may not need the approval of the President or Congress to raise or lower rates, but their mandate to maximize employment with debt as high as it is means they simply are beholden to what the government can (or more accurately can’t) pay for.
Why does any of this matter? Because it has severe implications on longer term inflation and deflation potential. If the Fed must continuously keep rates low, the "bond market bear" may never actually come. It also likely means equities will, at some point, become so extended relative to low rates that there won't be much to save them from an eventual deeper fall.
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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.
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