The Federal Reserve has the challenging task of unwinding years upon years of easy money, aka, our “monetary morphine genie”. Going from an ultra-low, accommodative interest rate environment (which has been great for businesses and consumers) to one more normalized, is not only inevitable, but mandatory. Overall economic health, particularly when it comes to paying down our federal deficit, depends on normalized rates. The quick pace of shoving that piggy genie back into the bottle, given the Trump administration’s fiscal policies (e.g., infrastructure spending and corporate tax reform), worries many economists, including those at the Fed.
There are a couple of ways this gorged genie could find its way back into the bottle with the right amount of grease. The first is inflation. A higher inflation rate means that future debt servicing will be made easier, as an inflated dollar makes prior debt obligations less expensive to pay down. This is a big ancillary benefit of inflation – making government debt more manageable.
The second way will be for the Federal Reserve to more proactively sell US Treasury securities through their FOMC activities, which reinforces the first way. After years of QE (“Quantitative Easing”) programs focused on buying up Treasury assets (mostly on the long-end of the yield curve), the opposite action of selling those same securities is a good tactic to more quickly unwind the easy money policy. In their recent report, BNP Paribas expects the Fed, in 2018, to begin reducing their balance sheet by about $4Trillion through a combination of naturally allowing bonds to mature and actively selling bonds. Such a move would indeed light a fire under the money markets, jumping closer towards historical interest rate levels.
Currently, US Treasury debt hovers around $20Trillion, and of that debt, nearly 60% is maturing within the next four years (chart above). That’s quite a bit coming due that will most likely need to be rolled to longer-dated issues, based on current federal deficit projections. If newly appointed US Treasury Secretary Mnuchin is smart (and thankfully, there’s evidence that he is), we’ll see ultra-long dated Treasury issuance (both, 50- and 100-Year paper) before year-end 2017, for the first time in US history. Doing so would go a long way to buying much, much more time for the US government to figure out how to balance its federal budget, and at a historically low cost.