Who will influence the world's most important Intrerest Rate? Bessent 'usurps' Powell

The U.S. Treasury Department tends to increase the issuance of short-term bonds, significantly undermining the independence of The Federal Reserve (FED).

Written by: Bao Yilong

Source: Wall Street Journal

The U.S. Treasury Department tends to increase the strategy of short-term bond issuance, which is substantially undermining the independence of The Federal Reserve (FED), and the authority of monetary policy may in fact shift to the Treasury Department.

This week, U.S. Treasury Secretary Besant clearly stated a preference for greater reliance on short-term debt financing, which contrasts with his previous criticism of his predecessor's over-reliance on short-term government bonds; this strategy is essentially equivalent to a fiscal version of quantitative easing.

In the short term, the Treasury's shift towards more issuance of short-term government bonds will stimulate the prices of risk assets to further deviate from their long-term fair value, structurally pushing up inflation levels.

The more far-reaching impact is that this will severely limit The Federal Reserve (FED)'s ability to freely formulate anti-inflation monetary policy, creating a pattern dominated by fiscal policy. The actual independence of The Federal Reserve (FED) has been eroded in recent years, and the surge in the issuance of short-term government bonds will further deprive the central bank of the space to freely formulate monetary policy.

Why Short-Term Debt is an "Accelerant" of Inflation

In the coming years, rising inflation seems inevitable, and the U.S. Treasury's decision to increase the issuance of short-term debt is likely to become a structural factor pushing up inflation.

Treasury bills, as debt instruments with a maturity of less than one year, have more "monetary" characteristics than long-term bonds. Historical data shows that the fluctuations in the proportion of Treasury bills in the total outstanding debt often lead the long-term fluctuations of inflation, which resembles a causal relationship rather than a simple correlation.

The rise of the current inflation cycle was preceded by the increase in the issuance of Treasury bonds that began in the mid-2010s, when the U.S. fiscal deficit first showed procyclical growth.

In addition, the explosive growth of the repurchase market in recent years has also amplified the impact of short-term debt. Due to improvements in the clearing mechanism and deepening liquidity, repurchase transactions themselves have also become more like currency.

Treasury bills usually achieve zero haircut in repurchase transactions, allowing for higher leverage. These government bonds activated through repos are no longer dormant assets on the balance sheet, but rather transformed into "quasi-money" that can drive up asset prices.

In addition, the choice of issuance strategy has a distinctly different impact on market liquidity.

A vivid example is that when the annual net bond issuance relative to the fiscal deficit is too high, the stock market often encounters trouble. The stock market fell into a bear market in 2022, which prompted then-Treasury Secretary Yellen to release a large amount of treasury bills in 2023. This move successfully guided money market funds to use the Federal Reserve's reverse repurchase agreement (RRP) tool to purchase these short-term bonds, thereby injecting liquidity into the market and driving the stock market's recovery.

Additionally, observations show that the issuance of short-term treasury bills is usually positively correlated with the growth of The Federal Reserve (FED) reserves, especially after the pandemic; whereas the issuance of long-term bonds is negatively correlated with reserves. In short, issuing more long-term bonds will squeeze liquidity, while issuing more short-term bonds will increase liquidity.

The issuance of short-term bonds provides a "sweet stimulus" to the market, but when the stock market is already at historical highs, investors are heavily positioned, and valuations are extremely high, the effectiveness of this stimulus may be difficult to sustain.

The Era of "Fiscal Dominance" Has Arrived, The Federal Reserve (FED) is in a Dilemma

For The Federal Reserve (FED), the irrational boom in asset prices combined with high consumer inflation, along with a large amount of outstanding short-term debt, constitutes a tricky policy dilemma.

According to convention, the central bank should have adopted a contractionary policy in response to this situation.

However, in an economy that has accumulated a large amount of short-term debt, interest rate hikes will almost immediately translate into fiscal tightening, as the government's borrowing costs will soar accordingly.

At that time, both The Federal Reserve (FED) and the Treasury will face immense pressure to loosen policies to offset the impact. In any case, the ultimate winner will be inflation.

As the outstanding balance of short-term government bonds rises, the Federal Reserve (FED) will be constrained in raising interest rates and increasingly unable to fulfill its full mandate. On the contrary, the government's massive deficit and its issuance plans will substantially dominate monetary policy, creating a situation of fiscal dominance.

The market's accustomed independence of monetary policy will be significantly undermined, and this is still the situation before the next Federal Reserve chairman takes office, who is likely to lean towards the White House's ultra-dovish stance.

It is worth noting that this shift will have far-reaching implications for the market in the long term. First, the dollar will become a casualty. Second, as the weighted average maturity of government debt shortens, the yield curve will tend to steepen, which means that long-term financing costs will become more expensive.

In order to artificially suppress long-term yields, the likelihood of reactivating policy tools such as quantitative easing, yield curve control (YCC), and financial repression will greatly increase. Ultimately, this could become a "victory" for the Treasury.

If inflation is high enough and the government can manage to control its basic budget deficit, then the debt-to-GDP ratio could indeed decrease. However, for The Federal Reserve (FED), this would undoubtedly be a painful loss, and its hard-won independence would suffer serious erosion.