Understanding the current political economy requires a grasp of a singular concept: debt. You don’t have to be an economist to see the implications of this fundamental issue.
What you need to recognize is straightforward. Debt—both public and private—has reached levels so astronomical that repayment is simply unattainable.
Instead, this debt will eventually be reconciled, either through defaults, inflation, or a mix of both. The forthcoming resolution of this issue is poised to be momentous.
As debt accumulates, it distorts markets. This distortion is apparent in the irrationality of housing and stock prices, as well as the unyielding rise in consumer costs.
Federal debt has recently surpassed $35 trillion. The Treasury holds the responsibility for this mountain of debt, yet it merely finances the deficit dictated by politicians in Washington, influenced by a vast array of special interests.
From defense spending to green energy initiatives, farm subsidies, and other pork-barrel projects, no expenditure is too extravagant for the government. Daily, countless agency employees perform tasks that often seem redundant or unnecessary. No wastefulness is too extreme when it comes to government spending.
The Treasury’s ability to finance these extensive deficits would have faltered long ago without the mechanism of debt-based fiat currency, enabling virtually limitless dollar issuance. Naturally, each new dollar of debt requires a corresponding lender. In the U.S., that lender is the Federal Reserve.
The Federal Reserve’s Recent Policy Decisions
This week, the Federal Open Market Committee (FOMC) convened to discuss monetary policy and set interest rates. Wall Street’s attention was primarily fixated on interest rates: Would the Fed lower the federal funds rate now or wait until September?
Following Wednesday’s meeting, the Fed decided to maintain the federal funds rate at 5.5 percent. This was largely anticipated, but indications suggested that rate cuts might be on the horizon for September. The following excerpt from the FOMC statement, unchanged since June, captured this sentiment:
“In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
Will the Fed gain the necessary confidence regarding inflation levels before the September meeting?
Probably not. It seems likely that Wall Street will need to wait until November for the long-anticipated rate cuts.
When the Fed ultimately does cut rates, it will mark the first adjustment since March 16, 2020, when the rate was slashed to nearly zero during the early days of the pandemic.
The mere prospect of a potential rate cut in September was enough for Wall Street, leading to a surge in indexes. On Wednesday, the S&P 500 climbed 85 points, and the NASDAQ rose by 451 points, although most of these gains eroded by Thursday.
In our view, optimism surrounding potential rate cuts is misplaced. Consumer price inflation remains significantly above the Fed’s target of 2 percent.
Fed’s Balance Sheet: A Looming Concern
The most recent PCE price index stands at 2.5 percent, with the latest CPI reading at 3.0 percent. Thus, the Fed has much work ahead to curb inflation. Maintaining the federal funds rate at 5.5 percent over a longer period could ultimately achieve this goal. Premature cuts risk reigniting inflation.
Nonetheless, cutting rates has become necessary to rescue banks from the underwater bonds acquired during 2020 and 2021. These cuts will also support the Treasury in financing an estimated $1.3 trillion deficit needed to get through the year’s end.
While market participants were primarily fixated on potential interest rate cuts this week, the more pressing story was being overlooked: the Fed’s balance sheet remains alarmingly extensive.
Before the financial crisis in 2008 and the initiation of quantitative easing, the Fed’s balance sheet was around $800 billion, approximately 6 percent of GDP.
Subsequently, from 2008 to 2014, the Fed expanded its balance sheet to $4.5 trillion. During the COVID-19 crisis, it swelled to $8.9 trillion by 2022.
The Fed’s assets mostly include Treasuries, mortgage-backed securities, and some corporate bonds. The mechanism by which the Fed acquires these debt instruments is enigmatic; essentially, it fabricates credit from nothing.
Since early 2022, the Fed has reduced its balance sheet by $1.6 trillion, bringing it just under $7.3 trillion. However, even at this level, it still represents 26 percent of GDP. Together with uncontrolled deficit spending, this immense balance sheet guarantees that consumer prices will never revert to their pre-pandemic levels.
The Ongoing Issue of Dollar Debasement
The FOMC statement this week included the usual implementation note, which often goes unnoticed.
This note stipulates that the reduction of Treasury holdings is capped at $25 billion per month, while the reduction of mortgage-backed securities is limited to $35 billion monthly. Before May 2, Treasury holdings were decreasing by $60 billion each month.
This slowing pace of balance sheet reduction ensures that the Fed’s total assets will never return to pre-2019 levels. In essence, the increase in the money supply witnessed from 2020 to 2022 is permanent.
Kevin Warsh, a former Federal Reserve Board member, recently shared insights in a Wall Street Journal article, stating:
“The Fed has reduced its balance sheet over the past few quarters, down 7 percentage points from its peak as a share of GDP. M2 is down about 3%. Consequently, less money printing has led to less inflation.
“If the Fed continues to shrink its holdings, price stability would be more easily attainable. However, Fed leaders appear committed to stabilizing their asset holdings. They cite falling wage increases and a softer job market as the cause of declining inflation. In my view, reckless government spending and excessive money creation are the primary factors behind inflation in the first place.
“Had the Fed recognized the inflation issue earlier, it wouldn’t have had to raise rates so dramatically. If the Fed’s asset holdings had been smaller or reduced more swiftly, inflation wouldn’t have escalated as it did. Hardworking Americans would not now bear the dual burdens of high prices and rising credit costs.”
Warsh’s insights should not be regarded as controversial. It is unusual for former Fed members to express such candid criticisms.
To conclude, the Fed seems to prioritize the interests of the privately-owned banks it serves over those of American workers, savers, and retirees. Therefore, regardless of whether the Fed opts for rate cuts in September or not, its commitment to combating inflation effectively ended months ago, when it began to slow its balance sheet reduction.
The policies leading to the debasement of the dollar perpetuate an ongoing distortion, ensuring that prices for goods and services remain unjustifiably high.
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Sincerely,
MN Gordon
for Economic Prism
Return from Dollar Debasement Ad Infinitum to Economic Prism
