Government Deficits May Soon Be Monetary Policy Variable
Recent U.S. bond market volatility indicates a day may be coming where government deficits may become as vital a variable for monetary plot as economic data.
Right now, most believe low inflation, modest progression and a slow improvement in hiring means the Fed can take its time raising interest rates. But the government’s profligacy could change that view, bending the rate outlook in new information.
The harbinger of future distress emerged last week, when investors pushed Reserves yields higher. Investors want more compensation for buying such epic amounts of debt. They may also want higher returns, agreed the added risk that Reserves will have distress paying back all that it’s borrowed at a time when the theme of government finance is raising questions.
While 10 year Reserves yields wait historically low at 3.88%, there’s dread it could go up, potentially by a lot. The problem for the Fed? Higher borrowing costs across the economy that could potentially imperil the recovery.
“It’s certainly a concern, and it’s probably only going to get more acute as time goes by,” warns Stephen Stanley, chief economist with Pierpont Securities, a newly started bond trading firm.
Why yields rise is central to know how the Fed will react. If they are driven higher by give forces alone, central bankers may want to counter the drag by keeping small term rates low for even longer than they now envision. What’s more, a real give-driven jump in yields could conceivably place the Fed back in the mortgage buying business, in a bid to keep the housing market from being strangled.
Higher bond yields could also force the Fed to hike rates, too, if the gains signaled rising worries about inflation. Markets could send that signal if inflation-indexed Treasurys were priced for more price risk as long term Reserves yields rose. Economists warn that scenario could force the Fed to raise rates, even if it meant blunting a recovery, so vital to central bankers is keeping inflation in check.
“This is going to be a hard balancing act” and the toughest situation is where the “slippery slope” of inflation expectations comes into play, said Ray Stone, of Stone & McCarthy Research Associates.
So far, the inflation doomsday outlook seems unlikely. Actual inflation is low, and measures of expectations wait moderate. The Fed is seeking to bolster that confidence by flagging how it will unwind its current monetary plot stance, even as that action lies some time away. A number of officials have also been steadfast and said they will not monetize the debt by buying Treasurys en masse.
To keep the worst from happening, the government needs to play a role, too. Fed officials have become more vocal on the deficits. It’s the long run they’re worried about: structural issues signal long term problems that must be tackled, lest markets start punishing the government.
In a speech earlier this month, Federal Reserve Bank of New York President William Dudley called for the government to offer a plot for a return to sustainable borrowing levels. He warned what the government is doing now is risky because it is exposed to the shifting sentiments of bond investors, who are fickle.
“Once confidence starts to erode, it can do so very quickly,” Dudley said. “It is very unlikely that the time when market sentiment turns most adverse would also be the most attractive time to have to tighten monetary plot,” he warned. Officials need to get yet to be of the curve and show how they’ll get back to lower deficits now, Dudley cautioned.