Markets may be missing the larger story. Professor Tim Congdon from the Institute of International Monetary Research said the Fed is aiding and abetting the monetisation of America’s deficits. “What on earth do they think they are doing?” he said.
Money supply growth may look moderate at first glance, but the true scale is disguised by a 15 per cent rise in US money market mutual funds over the last year to nearly $US7.4 trillion.
US Treasury Secretary Scott Bessent with US President Donald Trump. Bessent has been flooding the debt market.Credit: AP
The critical point is that these funds are allowed to buy only one kind of asset: short-term US treasury debt with less than a year to maturity. The $US900 billion rise in this form of deposits over the last year has mopped up half of Trump’s $US1.8 trillion borrowing needs.
“It is obvious that the money market funds are now crucial to the financing of the US federal deficit,” Congdon said.
Loading
Congdon further said that two-thirds of the entire deficit is now being monetised in one way or another. The US authorities are incubating another spasm of inflation a year or two hence, risking a repeat of the great monetary error made during the early phase of Covid. “They seem to have learned nothing,” he added.
Scott Bessent, the US Treasury secretary, has been flooding the debt market with record issuance of short-term T-bills, having denounced this practice as scandalous when conducted by the Biden administration last year.
The US Treasury has, in effect, been acting as a rival central bank, doing its own QE on the side. Stephen Miran, Trump’s economic guru and now his man at the Fed, said last year that this legerdemain was “backdoor stimulus” and “equivalent to a one-point cut to the Fed’s policy rate”. Well, indeed.
But now the Fed is joining the party by halting QT and preparing to become a net buyer of US debt. In one sense, it is a justifiable move. Money market rates have become unstable.
Stress has crept into the secured overnight financing rate. The spread on this rate has jumped to 16 basis points above the interest paid by the Fed on bank reserves, the highest since the financial tremors at the start of COVID.
The Fed has been burned before. A sudden spike in money market rates in 2019 damaged its reputation for competent management.
The move is questionable amidst 3 per cent inflation, 3 per cent growth or more, a general government deficit of 7.4 per cent of GDP, and a galloping bull market on Wall Street.Credit: Bloomberg
The Truss episode in 2022 spooked central bankers across the world over hidden dangers in dark corners of the derivatives market.
Bank of America’s Cabana said fresh bond purchases by the Fed would not be QE, but the markets might well conclude that it is. The spectacle of the Treasury issuing more T-bills that are instantly snapped up by the Fed “may look coordinated” and smack of “financial repression”, even if that is not the intention.
But what exactly is the intention of the Fed as Trump loyalists march through the institution, and the White House turns the screws on legacy Biden appointees?
Bernard Connolly, a veteran Fed adviser and author of You Always Hurt the One You Love: Central Banks and the Murder of Capitalism, said the Fed is edging crabwise along the primrose path to fiscal dominance.
“I don’t think they are deliberately attempting to fund the deficit, but what they are doing may have that effect. They don’t want to make it harder for the treasury to sell debt, so they are bending a little,” he said.
“In the end, central banks almost everywhere are going to face the issue of bailing out their governments. Fiscal dominance is unavoidable,” Connolly added.
If you stand back, the situation is already beyond bizarre. The Fed’s balance sheet is today $US6.6 trillion, or 22 per cent of GDP.
This is up from $US800 billion – or 6 per cent of GDP – since the QE blitz began after the Lehman crisis. Yet Fed insiders now say a bigger balance sheet is needed to keep pace with economic growth.
The ratio of reserves to bank assets is still 12 per cent, a level categorised as “abundant” by the New York Fed itself. The banks have just reported bumper earnings.
The Fed has been burned before. A sudden spike in money market rates in 2019 damaged its reputation for competent management.
Yet the Fed says the financial system needs more juice. As the French say, ça cloche.
The International Monetary Fund forecast in its latest Fiscal Monitor that the deficit of the US general government would rise to 8 per cent of GDP in the late 2020s and remain stuck at 7.6 per cent in 2030.
By then, the debt ratio will have rocketed another 20 per cent to over 143 per cent of GDP, crossing Italy and Greece on their way down.
The pitfalls of this were spelt out by one Stephen Miran two years ago in a piece while at the Manhattan Institute: “Eating Our Seed Corn: Runaway spending is eroding America’s ability to respond to future economic downturns.”
Loading
If the US enters another recession with a deficit above 6 per cent of GDP and federal debt in triple digits, he warned, it will lack the counter-cyclical punch to fight its way out of the crisis. “Running a pro-cyclical fiscal and monetary policy is a terrible idea,” he said.
It is hard to imagine a more pro-cyclical mix of prime pump policies than the US menu for 2026. The fiscal impulse will swing from a 1 per cent of GDP net drag this year to a 1 per cent net stimulus next year.
The US Treasury is monetising almost a trillion annually by the back door. The Fed is cutting rates to combat rising inflation. Soon, it will add the extra “coup de whisky” of fresh T-bill purchases. And all in time for the midterm elections in November 2026.
Forgive me for being an old cynic, but I would suggest that America is heading into an irresponsible financial boom akin to the final blow-off of the Roaring Twenties and the Roaring Nineties. The debasement trade is young yet.
Telegraph, London
The Business Briefing newsletter delivers major stories, exclusive coverage and expert opinion. Sign up to get it every weekday morning.
