What’s Ahead for the Fed—and Us?

A recent article in the Financial Times, “US debt ceiling fears cast shadow over Fed plans” reports that the Fed’s plan to stop quantitative easing might be imperiled by a Congressional stand-off over the US debt ceiling at the end of this September.

Our federal government’s debt limit is currently $19.8 trillion. If exceeded, the U.S. Treasury can’t borrow any more money. Unfortunately, we’ve hit that limit already back in March. Congress has been tweaking the law so that it had more time to do something about the debt limit.

The FT’s article mentions that a number of financial experts are worried because so far Congress’ and the President’s record on passing major legislation has remained at zero.

If their fears come true, there could be major spending cuts (insisted upon by the Freedom Caucus and other right-wing Republicans). Or even more worrisome, there might be a complete government shutdown.

Clearly this would impact the Fed’s plans! The Fed’s schedule for unwinding its huge debt might have to wait. This would create a crisis around the time of the next Presidential election as $777 billion of Fed debt comes due in 2018 and 2019.

Unwinding the Fed’s debt

The Fed has been planning, starting late this September, to begin unwinding the $4.5 trillion debt it took on its books during the Great Recession brought on by large investment banks in 2008-2009.

This debt is equal to almost a quarter of the entire U.S. debt ceiling!

Perhaps you wonder why the Fed shouldn’t just write-off this bad debt. The Fed is a non-profit entity. It is obligated to transfer its profits to the Treasury. If the money the Fed spent on bad debt isn’t recovered, Treasury’s options are to print money (perhaps causing inflation) or raise taxes (not something Congress will do).

The Fed plans to start getting rid of its debt this year by retiring long-term U.S. government bonds when they expire rather than issuing more bonds to sell to investors. This will save the government money on the interest premiums it pays out on Treasury bonds. The U.S. government will have more money” in its own pocket”.

However, this way of unwinding corporate bad debt held by the Fed will raise the demand for the government bonds that remain, causing their prices to rise. As the increased demand for bonds pushes their prices up, their interest rates will drop.

That’s because bond prices and interest rates move in opposite directions. The reason for this is that the seller of scarce, higher-priced bonds doesn’t need to offer as much of an incentive to buyers to get those buyers to buy their bonds.

Thus, it’s likely that unwinding the debt held by the Fed will cause long-term interest rates (yields) on government bonds to drop. This could outweigh the impact of the Fed’s practice of increasing short-term (daily) interest rates on banks and other large borrowers.

These short term interest rate rises by the Fed are designed to encourage banks to pass on the added interest costs to their customers. This means consumers pay more for goods.

If the Fed’s long-term interest rate drop cancels out its short-term interest rate rises, the Fed might even be headed for the negative-rate interest percentages that many other Central Banks in the world now offer to their government bondholders.

What would that mean for us?

Impact of Central Bank negative interest rates

This is where interest rates get really interesting!

We think the idea of investing in something that costs us money is crazy. However, this is exactly what we do when we buy some things.

For example, homeowners pay for security systems and or insurance in order to protect their houses. Their houses are a major asset they can’t afford to lose.

Thus for large investors, their money is an asset they can’t afford to lose. Paying a Central Bank a a small percentage fee for keeping their money safe is a small price compared to losing that money.

In an article titled, “Nothing cold about sub-zero rates, IMF researchers find,” Reuters reports that

Negative interest rates imposed by central banks have generally worked as a tool to boost inflation, pulling down yields [on bonds] and sometimes weakening currencies…[while] commercial banks for the most part have maintained their profits under such policy, cushioning margins with such tactics as not passing on all of a policy rate cut to customers.

This report, however, is based on countries with economies that have been struggling with deflation of prices in their country—not with huge Central Bank debt like the Fed carries.

For the United States, the high rate of job gain at the end of the last President’s term and the beginning of the current one’s has resulted in more money being spent by consumers and steady gains in prices, as well as an off-the-chart stock market.

A negative prognosis

The impact of negative Central Bank interest rates in this country would be to help pare down U.S. government’s debt and make banks better off, but Americans will pay higher interest rates on debt and more for goods and services.

It would become harder to pay bills let alone save. Even a tax cut for the whole middle-class may not be enough to keep heads above the water.

A positive prognosis

The Fed views its mission as balancing the negative impacts of high unemployment versus high inflation or deflation. Hopefully, the Fed will try to ensure while it unwinds its debt that too much inflation doesn’t happen too quickly for consumers to keep up with.

With well-over “full-employment” right now, there would normally be no reason at all for the Fed to worry about the economy—except for the fact of the Fed’s own huge debt and Congress’ inability to work together…

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