The Federal Reserve’s primary function is to intervene to provide liquidity during a financial crisis to prevent the system from collapsing. In normal (non-crisis) times, the Fed’s mandate is to provide a stable currency and maximum employment at the same time.
The Fed’s best-known tool is the overnight fed funds rate. Since the 2008 financial crisis, the Fed has also bought a large amount of Treasury and mortgage-backed debt, dramatically increasing in 2020 and 2021 due to the Covid pandemic. As Congress added fiscal stimulus at the same time that the Fed was adding monetary stimulus (while supply of goods and services was restricted due to the pandemic), inflation has been rising.
The Fed has announced that they will address inflation by speeding up the tapering of their bond purchases as well as increasing the fed funds rate in 2022. The Fed currently owns 25% of all marketable Treasury securities outstanding. The Fed’s balance sheet is 35.5% of GDP, an immense amount of fiat money that precludes any true market price discovery.
The linked article has an excellent discussion of the Fed’s assets.
https://wellsfargo.bluematrix.com/links2/html/4c0a1ede-8107-…
**Wells Fargo, January 13, 2022**
**The Fed's Balance Sheet: When Will It Shrink, and by How Much?**
**...**
**...Our baseline assumption is that the Federal Reserve will announce balance sheet runoff at the September 2022 FOMC meeting, with the actual runoff beginning one month later in October. Unlike the 2017 experience, we think the FOMC will also increase the federal funds rate at this meeting to 0.75%-1.00%....**
**[snip discussion of the last time the Fed tried to reduce its bloated book in 2017-2019]**
**Ultimately the impact on Treasury yields from projected Fed balance sheet runoff is highly uncertain, much more uncertain than the pass-through from projected fed funds rate increases. We think the most likely outcome is for upward pressure on long-term Treasury yields, but only moderately so. The structural downward pressure on real long-term interest rates from demographic changes, lower potential GDP growth and elevated global savings remains intense. These factors are reflected in our 2023 year-end forecast for the 10-year Treasury yield of 2.35%.** [end quote]
The article mentions “structural downward pressure on real long-term interest rates from demographic changes, lower potential GDP growth and elevated global savings” but fails to mention the elephant in the room – the downward pressure on long-term interest rates from the Fed’s overwhelming purchases of debt with fiat money.
The real yield of any bond is the nominal yield minus the inflation rate. Currently, all Treasury yields are negative at all durations.
https://www.treasury.gov/resource-center/data-chart-center/i…
So, what will inflation be like in a few years? The 5-Year, 5-Year Forward Inflation Expectation Rate is the difference between Treasuries and TIPS, but that’s bogus because the Fed buys 25% of TIPS issuance so they can control this number any way they like. If you think that inflation will rise above 2% in that time frame it makes sense to buy TIPS.
https://fred.stlouisfed.org/series/T5YIFR
If the 2023 year-end 10-year Treasury yield really is 2.35% the real yield will be negligible if inflation is 2% and negative if inflation is higher.
https://www.cbo.gov/publication/57218
https://www.cbo.gov/publication/57038
From the Congressional Budget Office
**In CBO’s budget projections (called the baseline), the federal budget deficit for fiscal year 2021 is $3.0 trillion, nearly $130 billion less than the deficit recorded in 2020 but triple the shortfall recorded in 2019. Relative to the size of the economy, this year’s deficit is projected to total 13.4 percent of gross domestic product (GDP), making it the second largest since 1945, exceeded only by the 14.9 percent shortfall recorded last year....**
**The Economy**
**As the pandemic eases and demand for consumer services surges, real (inflation-adjusted) GDP is projected to increase by 7.4 percent and surpass its potential (maximum sustainable) level by the end of 2021. The annual growth of real GDP averages 2.8 percent during the five-year period from 2021 to 2025, exceeding the 2.0 percent growth rate of real potential GDP. {** [This is wishful thinking, which assumes faster growth than the past 15 years and also no intervening recession. – W] **Over the 2026–2031 period, real GDP growth averages 1.6 percent, which is less than its long-term historical average, primarily because the labor force is expected to grow more slowly than it has in the past...**
**Once the effects of decreased revenues associated with the economic disruption caused by the pandemic dissipate, revenues measured as a percentage of GDP are generally projected to rise. After 2025, they increase in CBO’s projections largely because of scheduled changes in tax rules, including the expiration of nearly all the changes made to individual income taxes by the 2017 tax act. After 2031, revenues continue to rise—but not as fast as the growth in spending. Most of the long-term growth in revenues is attributable to the increasing share of income that is pushed into higher tax brackets....**
**Federal debt held by the public is projected to equal 202 percent of gross domestic product (GDP) in 2051, and the deficit is projected to equal 13 percent of GDP....** [end quote]
The very rapid growth of spending that does not invest in higher productivity is guaranteed to lead to inflation in many segments of the economy.
I don’t see how the Treasury and Federal Reserve can maintain demand for such a huge amount of debt without rising interest rates and/or inflation.
Wendy