Could Fed’s policy invite stagnation in just two years?

Will the big banks' capital cushion be absorbed as government continues to borrow and borrow?

Could Fed’s policy invite stagnation in just two years?

The Federal Reserve’s fiscal macroeconomic policy has been branded irresponsible and a move that could invite stagflation in just two years.

Brian Wesbury, chief economist at First Trust, believes the Fed has started a wrestling match with big banks over its MMT-led debt purchasing programme that could undermine its mission to spend more and more.

While the timing of the next increase in interest rates is now a constant debate, the central bank wants to keep them low for as long as possible. One way of doing that, Wesbury said, is to forecast higher inflation and real GDP growth so that when it occurs, it can say it’s not surprised, while still projecting low rates until 2024 or beyond.

He said: “As a result, the economy can accelerate to its fastest growth rate since the early 1980s and inflation can move above the Fed’s 2% target, all while the Fed sits back and yawns. Of course, the bond market has a say in things, too. Rapid growth and higher inflation could push up long-term interest rates even further, and at that point the ‘bond vigilantes’ may force the Fed’s hand. But the Fed feels confident that it has the tools to deal with this ... specifically, asset purchases.”

This is where issues may arise. Right now, the Fed is buying $80 billion of Treasury debt each month and $40 billion of mortgage-backed securities. It could raise the total every month, shift purchases to longer-dated Treasury debt, or it could buy fewer mortgages and more Treasuries.

“We think, in the end, the Fed will change its mix of bond buying and be pressured to lift rates before it now expects,” Wesbury said. “Either way, the change in its forecast has bought some time before it does either. And that’s good, because the Fed is now wrestling with an entirely different issue. In order for the Fed to operate within an economic policy that certainly looks like Modern Monetary Theory, it must purchase trillions of dollars of government debt.”

Big banks are required for this to happen, buying bonds from the Treasury before the Fed purchases them from banks by creating new reserves. The banks, therefore, end up holding either the Treasuries or the new reserves (deposits) that the Fed created to purchase them.

After the Global Financial Crisis, regulators and politicians made banks hold more capital so that shareholders, not taxpayers, would be on the hook for loan losses. The Fed brought in the Supplementary Leverage Ratio (SLR), which is a rule requiring banks to hold 5% capital against ALL their assets –including Treasury bonds and reserves.

Before the pandemic, this rule had little effect. But with the money now flowing through the system, the Fed stepped in and boughtmore than $2 trillion of assets, threatening to “overwhelm” the banks.

Wesbury said: “What did government do? It relaxed the SLR, and exempted banks from holding capital against Treasury debt and reserves. We don’t think banks should need to hold this extra capital against risk-free assets, especially when it is the government forcing them to hold them.

“Unfortunately, at the urging of progressive lawmakers, the Fed announced it would not extend the exemption beyond March 31 … while we can understand holding extra reserves to offset exposure to risky assets (and regulators can raise this requirement whenever they want), it makes no sense when required of non-risky assets.”

Why is this a potential problem? If banks eventually hit these new liquidity rule levels, they must stop accepting deposits, stop making business loans, or stop buying Treasuries. This has injected some fear into the market and stock prices.

Right now, banks can easily absorb the increasing Federal debt but more is coming. The U.S. government just passed another $1.9 trillion bill which must be financed by borrowing, and the Fed is scheduled to buy $1.4 trillion in assets this year. President Joe Biden also wants to pass another $2 trillion to $4 trillion infrastructure bill. GDP is also expected to expand to 6% this year, increasing the demand for business.

Wesbury said: “In other words, as the future unfolds, the cushion of capital will be absorbed. Banks have said they face no near-term problems and we don’t disagree. Lending can continue as the economy picks up. But in the longer-term this regulation threatens to undermine the government’s desire to spend more and more.

“While we expect the Fed to escape the dangerous downside to these new rules, we are also cognizant of the fact that the US has entered an unprecedented period of government regulation and growth. Former Clinton Treasury Secretary Larry Summers has called it ‘the least responsible fiscal macroeconomic policy we’ve had for the last 40 years’.

“We think he is right about the irresponsibility, but wrong about the time period. It’s not the past 40 years, it’s the entire history of the United States. In the near-term, investors are safe from the stagflation we saw 40 years ago. But, as 2023 rolls around we aren’t so sure. So, stay positive for now, the worries are long-term.”