Unveiling the Fed's Aggressive Rate Hiking Cycle: Implications for US Banks and Government Finances

Governments vs. central banks – who backstops who?

by Ryan Shea

Key Take-aways

• The Fed’s decision to implement its most aggressive rate hiking cycle in over 40 years before trimming its balance sheet has not only hurt US commercial banks, it has experienced some hefty mark-to-market losses on its own balance sheet.
• Obviously, central banks cannot go bust. Indeed, several have operated with negative equity because the conventional wisdom is they are backstopped by the government.
• This is all well and good when government finances are in good shape, but they aren’t. Debt is near record highs and the outlook is extremely precarious considering the demographic time bomb in the form of population ageing.
• The default get-out-of-jail-free card of structural reforms, such as raising the retirement age and/or streamlining healthcare provisions, are not as easy to enact as often presumed - the current riots in France being a timely reminder of this.
• As much as central banks pretend to be independent guardians of price stability, it is hard to pick a fight with a fiscally profligate government if your actions mean you will probably need to go to them for a bailout or recapitalization.
• If governments are unwilling or unable to cut spending, and taxes – already at 65 year highs – can’t be raised further to finance future spending, central banks will eventually be forced to deploy the printing press.
• That is their and the government’s ultimate backstop.

In the preceding research note I pointed out that some US banks – primarily the smaller, regional banks – have been negatively impacted by the Fed’s decision to favour interest rate hikes over QT when it implemented its most aggressive monetary tightening cycle in over 40 years. However, the problems don’t stop there, even the Fed has experienced some issues. As I noted in a recent comment¹ (reprinted in French in the La Tribune newspaper²)

“Due to its previous QE programmes, the Fed is sitting on over $5tr of US Treasury Securities even taking into account the more recent QT programme. Earnings remittances due to the US Treasury – essentially, the mark-to-market loss on the Fed’s balance sheet, have increased to around $40bn – see chart.

To be clear, the Fed cannot go broke in the same way as Silvergate or SVB (it can always print!) but the optics of a central bank that owes its government $40bn as a result of losses on its own portfolio of Treasuries bailing out US commercial banks that have witnessed balance sheet impairment for the exact same reason is far from perfect.”

Problems Ahead?

As per the above quote, central banks cannot go broke. Indeed, several have operated with negative equity for some considerable time³. Conventional wisdom allows for such situations based on the presumption that the government will step in and provide fiscal support, namely commit to recapitalize the central bank if necessary. Recently, however, both the IMF⁴ and the BIS⁵ have expressed concerns that this could undermine the independence of the central bank, with the BIS warning that “episodes of negative equity or recapitalisation should not be an opportunity for the government to exert pressure on how the central bank discharges its mandates.”

But why might that be the case? The answer lies not in monetary but fiscal policy.

Monetary policy impacts both nominal interest rates and nominal GDP growth, two variables that directly influence the sustainability (or not) of the government’s finances, meaning there are fiscal spillovers from monetary policy. When government debt levels are low, these spillovers are modest, and the government is unlikely to be overly perturbed by the central bank actions implemented to satisfy its price stability mandate. However, when government debt levels are high, these spillovers are considerably greater and the potential for monetary and fiscal objectives to clash increases.

As I have observed before⁶, government indebtedness is already very elevated by historic standards (near peace-time record highs) meaning the potential for monetary and fiscal clashes is also elevated. Bad as that may be, when one peers over the immediate horizon the situation becomes even more disturbing. The charts below, for example, show the OECD’s fiscal projections including and excluding the impact of ageing populations⁷ over the next four decades – they are far from pretty.

OECD Fiscal Projections (% GDP)

Source: OECD

As I have observed before⁶, government indebtedness is already very elevated by historic standards (near peace-time record highs) meaning the potential for monetary and fiscal clashes is also elevated. Bad as that may be, when one peers over the immediate horizon the situation becomes even more disturbing. The charts below, for example, show the OECD’s fiscal projections including and excluding the impact of ageing populations⁷ over the next four decades – they are far from pretty.

OECD Fiscal Projections (% GDP)

Tackling these so-called unfunded liabilities constitutes a major challenge for politicians. Firstly, due to their slow moving nature, the impact of demographics - no matter how detrimental - far exceeds the attention spans of most politicians, which let’s be honest is measurable in seconds in this social-media-dominated age never mind four-year election cycles. Secondly, the default get-out-of-jail-free card of structural reforms, such as raising the retirement age and/or streamlining healthcare provisions, are not as easy to enact as often presumed. The problem is the public has a strong sense of entitlement when it comes to these… er entitlements.

Just look at the recent uproar in France following President Macron’s decision to raise the retirement age from 62 to 64. Worried he would not get the backing of MPs, Macron invoked the 49.3 procedure to avoid having to put it to a National Assembly vote. Needless, to say, this did not go down well with elected officials nor the public⁸. In fact, two censure motions were tabled against the government, which they only very narrowly won (one of the two motions fell short by only 9 votes⁹), and there have been widespread riots and protests – see image.

Source: twitter

Like reversing QE, structural reforms to trim future government spending is far easier said than done¹⁰.

Taxing Times

The government’s budget constraint means that its spending can be financed in three ways: taxation, debt (future taxes) or printing money¹¹. If the government is unable, or unwilling, to implement future expenditure cuts, then either tax or debt issuance needs to rise if the printing money option is to be avoided.

One of the most famous relationships in economics is the Laffer Curve¹². It is a hump-shaped curve defining the relationship between the tax rate and government tax revenues. Its peak defines the socially-determined constraint on how much tax rates can increase before they have a depressing effect on overall tax revenues due to tax avoidance and/or due to reduced incentives to work (meaning less economic activity). It is hard to know a priori whether economies are at - or beyond - the peak of the Laffer Curve, but what we do know is that there is a peak and for the OECD region as a whole, tax revenue as a percentage of GDP is at its highest level (34%) in over 65 years¹³. This strongly suggests that the scope for governments to finance higher future expenditures out of taxes (either now or in the future) is rather limited.

That leaves either debt issuance or printing money.

Debt issuance can plug the gap for a while but not indefinitely because the private sector will only hold government bonds when debt-to-GDP ratios are rising if they are incentivized by higher interest rates (additional yield) to compensate for the perceived increase in credit risk. However, higher interest rates worsen debt sustainability. Wash-and-repeat a few times and this is how sovereign debt crises occur.

Circuit Breakers

Of course, central banks can step in and short-circuit this process by putting their balance sheet to work and holding bond yields down. However, a central bank cannot target nominal bond yields and inflation simultaneously, there are not enough monetary policy degrees of freedom. Eventually one of them has to give and history suggests that it is inflation that acts as the release valve. For example, yield caps were adopted by the US as part of the reflationary efforts to escape the Great Depression and they were maintained during WWII in support of military spending. In fact, they were only removed in 1951¹⁴ after inflation has substantially eroded the level of US government debt (from a peak of 120% of GDP to 75% of GDP in 1951).

More recently, since 2016 the BoJ has operated a yield curve control (YCC) policy, which targets a 0% nominal yield on the 10-year Japanese government bond (JGB)¹⁵. Admittedly, Japan introduced the policy because it has struggled with deflationary pressures for much of the past 30 years and, no doubt, many are tempted to conclude that Japan exemplifies why the “Printer Go Brrr” meme is invalid. However, my response is this: Japan may not have experienced much inflation over the past two decades, but with Japanese government debt having risen to more than 230% of nominal GDP and with the central bank owning more than half of the outstanding JGB issuance, how exactly do they think this ends?

In keeping with the global trend, Japanese inflation started to move higher last year, and on the latest read is 4.3% on a headline basis and 4.2% on core. This is a 40 year high and more than double the BoJ’s 2% target. What has been the BoJ’s response? Very little. Its key interest rate remains unchanged at -0.1% and the central bank’s 10-year yield target is still 0% although it did widen the band to +/- 50bp either side.

According to the minutes from the January BoJ monetary policy meeting, the reason for not following in the footsteps of other developed central banks and jacking up interest rates is that it doesn’t want to be too hasty and is instead seeking to achieve the inflation objective in a “sustainable and stable manner”¹⁶. Perhaps, having failed to reflate the Japanese economy previously BoJ policymakers are suffering a bit of deflation PTSD, but there is likely another reason.

At the end of 2022, outgoing Governor Kuroda revealed the BoJ’s decision to widen the band on their yield target by just 25bp (the upper limit rose from 0.25% to 0.50%) meant the market value of its JGB holdings was ¥8.8tr lower than its book value – that’s a mark-to-market loss of $68bn.

Imagine the losses if JGB yields had moved up as they have done in the rest of the world?

Who would bail them out?

The Japanese government that has the highest debt-to-GDP ratio in the world, whose population is rapidly ageing and is now faced with rising debt servicing costs?!

I don’t think so.

Fiscal Dominance

The BoJ’s independence is a mirage - fiscal dominance is the new game in town. It may have taken much longer than many Japanese bears expected, but the monetary/fiscal situation in Japan is increasingly untenable. Once the Japanese population finally gets that the only way out of their government’s fiscal predicament is higher (probably much higher) inflation, the situation could unravel very quickly.

I appreciate that for many people who have become accustomed to central banks operating independently from the government such outlooks may seen far-fetched, but they are not. If central banks had been able to demonstrate they could contract their balance sheets in pursuit of their price stability mandates, this would have sent a strong signal to investors, and the public more generally, that their policy independence was secure. However, they have been unable to do so and doubts are creeping in. Indeed, as per the aforementioned House of Lords report¹⁷, one of the committees conclusions was:

“Quantitative easing has also made Bank of England and HM Treasury policymaking more interdependent, blurring monetary and fiscal policy, and this has started to erode the perception that the Bank has acted wholly independently of political considerations. We are concerned that scepticism of the Bank’s stated reasons for quantitative easing grew significantly during the COVID-19 pandemic, when many market participants said that they believed the Bank of England had used quantitative easing primarily to finance the Government’s deficit spending. If such sentiments continue to spread, the effectiveness of the Bank’s policies will be threatened severely.”[Ed note: my emphasis]

This is a slippery slope.

Who’s Got Your Back?

Conventional wisdom may be that central banks are backstopped by the fiscal authority. But, if tax payers are tapped out, meaning governments are unable to generate tax revenues (either now or in the future) sufficient to ensure that the present value of future budget surpluses are at least equivalent to the current debt load, the ultimate backstop is the printing press which can be deployed to finance government fiscal deficits. To be clear, this represents a deliberate policy choice on the part of the government. It may be far from current ideals, but in the absence of viable policy alternatives, needs must.

Central banks like to pretend that they are independent guardians of price stability, but this is of course not true. First, off most are under public ownership and if necessary central bank personnel can be change – a hiring decision that is at the behest of the government. Second, due to their prior QE programmes they have bloated balance sheets full of government bonds that lose money when they jack up interest rates. It is hard to pick a fight with a fiscally profligate government if your actions mean you will probably need to go to them for a bailout or recapitalization.

Inevitably, this debt-load-eroding-inflationary-process means the purchasing power of fiat money also gets eroded. If history is any guide – and in my judgement this represents the best-case outcome given the dire fiscal outlook – fiat money’s purchasing power will have to drop at least another 20-30%¹⁸. Given Bitcoin went from zero to $30-60k during the 20 point decline in fiat money’s purchasing power since 2009, imagine what another 20 percentage point decline will do? This is exactly what crypto investors are anticipating with the “Printer Go Brr” meme.

I appreciate that such scenarios may sound far fetched, even downright crazy, but crazy things happen all the time in the world of money, macro and markets. It is what makes attempting to analyze them so challenging and fun.

After all, who would have predicted that 15 years ago as the world suffered its deepest recession in living memory, an anonymous person would – before disappearing two years later without trace - be able to turn a few thousand lines of source code into a project valued at $550bn (a market cap equal to the 9^th largest company in the world).

That is crazy, but it happened nonetheless.

Until next time.

Ryan Shea, crypto economist

Footnotes

1See: https://www.linkedin.com/pulse/btfp-enough-reassure-public-ryan-shea%3FtrackingId=ojzVzkNCoVvtNKNOFw8Xyw%253D%253D/?trackingId=ojzVzkNCoVvtNKNOFw8Xyw%3D%3D

2See: https://www.latribune.fr/opinions/le-futur-selon-la-tribune/le-filet-de-securite-prevu-par-la-fed-pour-renflouer-les-banques-pourrait-ne-pas-suffire-955385.html?utm_term=Autofeed&utm_medium=Social&utm_source=Twitter#Echobox=1678953347

3See: https://www.piie.com/blogs/realtime-economics/central-banks-are-incurring-losses-critics-concerns-are-overblown

4See: https://www.imf.org/en/Publications/fandd/issues/2023/03/rethinking-monetary-policy-in-a-changing-world-brunnermeier

5See: https://www.bis.org/publ/bisbull68.pdf

6See: https://blog.trakx.io/crypto-wager/

7Ageing populations are also likely – due to less labour force participation – likely to lower potential, or non-inflationary, growth rates in the economy another significant negative when it comes to assessing government debt sustainability.

8See: https://apnews.com/article/pension-macron-france-protests-f37b065364be17db72e27dffc2a96d2d

9See: https://www.bloomberg.com/news/articles/2023-03-20/macron-government-survives-no-confidence-votes-over-pension-bill?srnd=economics-v2

10The repeated calls for structural reforms from the likes of the OECD, IMF and numerous central bankers is clear evidence that progress on this front has been extremely limited.

11That is to say, ruling out default.

12See: https://en.wikipedia.org/wiki/Laffer_curve

13See: https://www.oecd.org/tax/tax-policy/revenue-statistics-2522770x.htm

14Their removal was known as the Treasury-Fed Accord – see: https://www.federalreservehistory.org/essays/treasury-fed-accord

15I anticipated this policy would be implemented two years before it was introduced, much to the mirth of my colleagues at the time, who thought such things impossible - see: https://www.blackswaneconomics.com/pdf/GMT%20-%20Exit%20(22_12_14).pdf

16See: https://www.boj.or.jp/en/mopo/mpmsche_minu/minu_2023/g230118.pdf

17See: https://committees.parliament.uk/publications/6725/documents/71894/default/

18The two prior occasions when fiat money’s purchasing power fell resulted in a cumulative loss of between 40-50% and we are already half way there – see: https://blog.trakx.io/crypto-wager/