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spell1A  printing press is a handy thing to have. When a government or central bank can fund itself with money or claims on money, it can buy a lot of things and solve a host of problems, all without the need to tax. I wish I had one.

Developed world governments have lots of problems these days and hence are using the printing press overtime. And with lots of problems comes the thought, at least to an orderly mind, to somehow prioritize the buying. Or, if there is no order, than the disorder of whatever comes next is the order.

This Great Recession experience of the past five years has been an epic chapter of buying in the nearly 100-year history of the Federal Reserve.

In the modern era, economy-wide sustainable growth has been the Fed’s guiding light. It worked quite well for some 50 years to temper the oscillations of the business cycle, both the highs and the lows. And the modern business cycles orthodoxy and Keynesian upbringing is causing the Fed to turn on the printing press to achieve an unemployment rate of 6.5% in this Great Recession, so they claim.

While defining success in terms of unemployment brings clarity as to what Fed policy is about, it opens up monetary policy to an unintended exit if factors other than economic recovery were to reduce unemployment. And financial markets in a bubble state as a result of the Fed’s buying fear that outcome.

As it happens, labor force dropout due to demographics or inadequate skills is occurring. Furthermore, work is being reorganized and parceled out so employees do not exceed 30 hours per week, lest their employers become subject to the Obama Health Care tax. All these factors are bringing down the unemployment rate more quickly than fundamental economic improvement.

Each month, there is a dread fear in financial markets that unemployment will decline sufficiently to cause the Fed to exit QE as they have pledged. Indeed it is the major risk to investors holding positions in an asset bubble market, whether it be in debt, equity, commodities or real estate.

spell2So as we approach the target unemployment rate without much economic recovery, the question is, can and will the target be redefined to be the unspoken necessity of supporting Treasury debt obligations? 

The last time the priority of Fed buying switched from supporting banks and the economy to supporting the government effort to sell Treasury bonds was at the beginning of WWII.

In the three months following Pearl Harbor, given the expectations of the size of wartime debt issuance and with some inflation expectations thrown in, long Treasury yields ratcheted up.

The Fed then approached Treasury (not the other way around) indicating its willingness to enter an agreement to support Treasury bond prices at the March 1942 level for the “duration” of the war.

The Fed did this by buying enough Treasuries along the yield curve to prevent their prices from falling and the market yields from rising — a policy that became known as the Fed’s interest rate peg. It took a tripling of the Fed balance sheet in four years to do the job, which is roughly in the same league as the Fed balance sheet growth since the commencement of the Great Recession.

When the war concluded, federal government deficits turned into surpluses, and there was no longer pressure for the Fed to be the buyer of net new government debt.  And furthermore, there was high inflation. This caused the Fed to claim the “duration” had arrived and that it was time to exit (there’s that word again).  But there was a catch.

To Treasury Secretary John Snyder, exit in the name of economic stabilization was all academic heresy or a potentially expensive distraction from the core responsibility of a government to finance its debt at the most affordable rates. That is, he didn’t care for the idea that Treasury bonds would not be supported ad infinitum at par in the primary and secondary debt markets. Furthermore, he was backed by a gentleman in the White House by the name of President Harry S. Truman. Such is the core concern of a government as to the cost of its interest expense.

The Fed’s post-WWII exit attempt spilled over into widely followed Congressional hearings conducted by Senator Paul Douglas before the Joint Economic Committee. The core question was, did the Fed’s responsibility for full employment and controlling inflation trump the need for propping up the price of Treasuries so interest rates would not rise?

Despite Congressional support for the Fed to exit, it still took years until the Fed became determined to pursue a path independent of Treasury dictates, as inflation soared at the commencement of the Korean War.

While the brouhaha concerning exit continued from 1946 until 1951, an opportunity to back out of the Treasury bond support agreement occurred in 1951 (almost six years after the “duration”). At that time Treasury Secretary John Snyder was incapacitated and in the hospital and his next-in–line at the Treasury, William McChesney Martin, negotiated an exit agreement with the Fed at the White House with the President presiding. The agreement became known as the Accord and was the monumental turning point that allowed Fed independence to foster economic growth without inflation for the next half century.

However, there was a catch. The Accord set the Fed free to pursue economic stabilization so long as there continued to be a strong tilt to Treasury bond support. To accomplish that, Martin suggested, or perhaps insisted (as the folklore goes) that he be installed as Chairman of the Federal Reserve Board of Governors to represent Treasury’s interests in monetary policy — which required a resignation of the existing Fed Chairman. This was all accomplished before Snyder left the hospital. Such is the difficulty of Fed exit when the government’s ability to sell debt and service the interest expense is at stake. (For a revealing account of that history go here.)

What was most interesting about the 1951 exit is that after becoming Fed Chairman, Martin had a Beckett moment, or more like a Beckett career. In his almost 20 years as Fed Chairman he constantly tilted in the direction of containing inflation and would not peg Treasury rates below market even during the Vietnam War, which caused Lyndon Johnson to unsuccessfully seek his resignation.

In the context of today’s financing strains that will grow over the next four decades due to Boomer entitlements, consider the following: The U.S. gross debt-to-income ratio is in excess of 100%, and the CBO projects that ratio to reach 400% in the out years of entitlement growth. Hence, each hundred-basis-point increase in the average interest rate the U. S. pays to service its debt (above the present 2 percent average carrying cost) requires additional taxes to drain another percentage point from the income stream — a drain we can ill afford. You can do the math for the required tax drain when the debt-to-income ratio approaches 200% or 300% and if interest rates were allowed to reflect sovereign or inflation risk.

The CBO has estimated that in the out years of  Boomer entitlements, tax revenues will need to be as much as 25% of annual income as compared to today’s 2% to merely service the projected interest expense on the debt, (even if market yields were to remain at average historical levels).

spell3Today there is a de facto peg already in place. It goes under the title of zero interest rate policy (ZIRP). It is also known as financial repression, which includes ZIRP along with positive inflation causing real yields to go negative all the way out to almost 20 year maturities and has become the explicit policy of the Japan and implicitly of Europe as well.

Given the perspective of the machinations at the end of WWII, is it reasonable to expect that Treasury (and the President and Congress) will allow the Fed to exit its already existing de facto peg? The new “duration” is the length of the entitlements.

Hence, the only likely exit for Fed QEs is an exit from the pretense that QE is an economic stabilization policy that can go away if unemployment hits the Fed’s target. It’s a cover story that is about to be uncovered. Fed buying is the supporting backbone of the Treasury bond market with $500 billion in annual purchases which, in turn, promotes foreign central bank currency wars. With the proceeds, they are investing as much as the Fed is in U. S. Treasuries.

Hence, current Treasury Secretary Jack Lew will have an important say as did John Snyder, in the selection of the next Fed Chairman (if he doesn’t wish to stand in himself). The change of guard will likely occur before the year’s end, when Bernanke returns to Princeton to write his account of the Great Recession.

Hence, what needs to be built is a graceful institutional transition for the Fed to exit stated economic stabilization priorities in favor of Treasury debt priorities without actually exiting its asset purchase program. Otherwise the Fed will morph from one pretense to another as they have done with a loss of their credibility.

So relax, bond market, interest rates will be pegged until inflation is no longer containable at the 2.5% level and that could well not stop them.


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Is the Printing Press Engaged for the Duration? — 21 Comments

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