The Fed Checks Into The Hotel California

Macro Tides Monthly Report 03 October 2020

Record Deficits and No Real Growth

It has long been a tenet of economics (i.e. decades) that large budget deficits are bad since they can at least drive up the level of interest rates and lead to less private business investment. Crowding out, as it has often been called, can hurt economic growth as companies are either unable to borrow money to fund investments or curtail investment if interest rates rise too much.

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This theory is widely accepted as its logic is compelling and has been advocated by those who support the concept of a balance budget. It is said that if households can’t run a budget deficit year after year then governments should operate no differently.

The U.S. government has a fiscal year that ends on September 30 and through August the 2020 deficit was $3.007 trillion. The Congressional Budget Office (CBO) announced on September 9 that the U.S. government budget deficit will triple this year to $3.3 trillion, and as a percent of GDP will reach 16% the highest level since 1946.

In the coming decade through 2030 the CBO estimates that the annual deficit will be -4.5% of GDP despite a growing economy. The CBO projects an average GDP growth of 1.7% per year. With the annual deficit expected to be -4.5%, while GDP grows 1.7%, the ratio of federal debt held by the public to GDP will rise to 107% in 2023, above the level reached in 1946 and the highest in history.

The longest economic expansion in U.S. history ended in March 2020 more than 10 years after it started in June 2009. Despite this favorable economic environment the federal government ran a cumulative budget deficit of 38.9% in the nine years from 2011 through 2019, averaging -4.3% per year. Using 2011 as the starting year eliminates the big deficit years of 2009 and 2010 and is more than 18 months after the economy bottomed in June 2009.

Cumulative GDP growth in those 9 years totaled +20.4% and averaged +2.3%. Without annual deficit spending of -4.3% GDP, growth would have been negative for this 9 year period as this example shows. If GDP is $20 trillion at the beginning of a fiscal year, it would increase $460 billion with GDP growth of 2.3% and end the year at $20.46 trillion. However, the budget deficit in that year would have totaled $860 billion to represent -4.3% of GDP. Can we spend ourselves into prosperity? The jury is still out but we have been doing just that since 2011.

Who Owns Our Public Debt?

Federal debt held by the public is the amount of federal debt excluding debt held by other intragovernment agencies.

As of August 12 the Social Security Trust fund held $2.9 trillion of Treasury debt, the Office of Personnel Management Retirement fund had $929 billion, with $913 billion in the Military Retirement Fund, $226 billion in Medicare, and $253 billion in other retirement funds. When public debt is combined with intragovernment debt, the total debt of the U.S was $26.5 trillion or more than 125% of 2020 GDP.

Debt held by the public represents 77% of the total and just over $20 trillion, with intra-government agencies holding the balance. U.S. pension funds, mutual funds, insurance companies, state and local governments and individuals own $9.1 trillion of public debt. The Federal Reserve owns $4.44 trillion of Treasury debt after increasing its holdings significantly in recent months.

Foreign governments hold $7.1 trillion or 35%, with Japan holding $1.26 trillion, China $1.07 trillion, followed by the United Kingdom at $445 billion and Ireland with $330 billion.

In recent years China has lowered its holdings of Treasury securities from $1.25 trillion as they diversify their $3.154 trillion in foreign exchange reserve holdings. On September 4 Xi Junyang, a professor at the Shanghai University of Finance and Economics said:

“China will gradually decrease its holdings of U.S. debt to about $800 billion under normal circumstances. But of course, China might sell all of its U.S. bonds in an extreme case, like a military conflict.”

This has often been referred to as China’s nuclear option and while it would be disruptive, I suspect the Federal Reserve would purchase every Treasury bond offered for sale. The Federal Reserve justified buying high yield corporate bonds in March in order to address a liquidity problem in the corporate bond market, so the Fed would certainly step up to the plate and buy to avoid a disruption in the Treasury bond market.

In 1981 the public debt to GDP ratio in the U.S. was 31% according to the Federal Reserve of St. Louis and rose to 64% as of June 30, 2008. The 10-year Treasury yield peaked in September 1981 at 15.4% and by June 2008 had fallen to 3.99%.

If an economist was prescient enough in 1981 to forecast that the U.S.’s public debt to GDP ratio would double between 1981 and mid 2008, and then asked where they thought Treasury interest rates would be it is unlikely any economist would have predicted Treasury rates would have fallen from 15.4% to 3.99% in 2008.

Using June 30, 2008 as the demarcation point makes sense as the financial crisis didn’t erupt until September 2008 and the Federal Reserve’s first Quantitative Easing program wasn’t launched until December 2008. Given the widespread belief that excessive debt would at least push interest rates up in order to attract buyers, no one would have surmised how low the 10-year Treasury yield would be in 2008.

Correlation between Debt and Interest Rates

Since 1981 U.S. corporations have become increasingly less dependent on banks for funding. Bank loans as a percent of total corporate debt have dropped from 40% in 1981 to 17% at the end of 2019.

With corporations less reliant on banks for funding, they became more dependent on the corporate bond market and thus more vulnerable to crowding out as the supply of Treasury bonds increased and the changing whims of investors.

The shaded areas on the Nonfinancial Corporate debt chart are periods of recession. Corporations cut back on debt during and after recessions, until the economy is strong enough to warrant an increase in business investment. Since cash flow is not sufficient to fund business investments, corporations use debt to fund projects, which is why Nonfinancial Corporate debt increases during expansions. In 1981 non financial corporate debt was 30% of GDP and by June 30, 2008 it was 44.3%, an increase of almost 50%.

Even as the U.S. Treasury was issuing more bonds every year after 1981 and the public debt to GDP doubled, corporations had no trouble finding willing buyers. This allowed corporations to reduce their dependence on banks for loans and significantly increase the amount of corporate debt, so the problem of crowding out never materialized. Corporate bonds yields topped in 1981 along with Treasury yields and continued to fall even as the Treasury and corporations borrowed more.

Treasury and Corporate Bond Spreads

Although Treasury and corporate bond yields trended lower after peaking in 1981, there have been bumps in the road each time a recession developed as noted by the shaded areas. During recessions corporate defaults increase especially for lower quality bonds issued by corporations that have weak balance sheets. Default concerns lead to increased selling of corporate bonds, which causes the spread between Treasury yields and corporate bond yields to rise.

Highly rated corporate bonds (Moody’s Aaa) fall less than High Yield corporate bonds since they have much higher default rates. During the 2002 recession the spread for Aaa rated bonds was only 2.5% above the 10-year Treasury yield. In comparison the High Yield spread was 10.1% in 2002, and a whopping 20.0% compared to 2.7% for Aaa corporate bonds during the financial crisis.

Unprecedented Intervention by the Federal Reserve

In March 2020 the Federal Reserve announced it would buy corporate bonds including high yield corporate bonds. The impact of this unprecedented action immediately lowered spreads for Aaa and high yield bonds, even as the U.S. experienced the largest single quarter decline in GDP in history. The increase in spreads was even less wide than in 2001, which was an extremely shallow recession that lasted only 8 months.

The Fed’s intervention has also enabled corporations to sell the largest amount of corporate bonds in history 2020, as emboldened investors believe the Fed will protect them. Investor’s willingness to buy Junk bonds is a reflection of over confidence and excessive bullishness.

Corporations have further taken advantage of this opportunity by selling longer dated bonds that has lifted the duration of the Bloomberg Barclays Corporate Bond Index from 7.1 years in October 2018 to 8.7 years in September 2020.

The lengthening of duration increases the investment risk from any increase in corporate bond yields, but buyers are dismissing this risk because of the Fed. Buyers are assuming additional interest rate risk since the spreads over Treasury yields are so low (2 charts just before start of this section).

The risk of an increase in corporate bond defaults is likely underpriced as corporate bankruptcies are to date running much higher than in the 2001 recession and even during the financial crisis in 2008-2009.

As noted in the September Macro Tides banks significantly increased lending standards for every type of credit in the second quarter. A whopping 71.2% of banks increased lending standards for Commercial and Industrial loans for large and median sized firms and 70% did for small companies.

In the last 30 years an increase in lending standards has proven a good leading indicator of a subsequent increase in the default rate for High Yield corporate bonds. The increase in lending standards suggests the high yield default rate could rise to 10% or higher from 6%. The Federal Reserve can support corporate bond prices, but it can’t prevent a solvency crisis from overwhelming companies most affected by the Pandemic.

After the dot.com bubble burst in 2000 the Federal Reserve lowered the federal funds rate from 6.5% to 1.0% in June 2003, and didn’t begin to increase it until July 2004. By maintaining short term rates so low for so long, the Federal Reserve enabled the housing crisis to build as home buyers could buy a home and get an exotic mortgage tied to short term interest rates or mortgages that allowed the buyer to simply pay interest. In the wake of the housing bubble collapse the Federal Reserve slashed the federal funds rate to 0.12% in January 2009 and didn’t raise it until December 2015 almost 7 years later. After lowering the federal funds rate to 0.12% to confront the COVID-19 Pandemic, the Federal Reserve bought corporate bonds for the first time in its history and likely outside the range of its charter.

Zombie Corporations Emerge and Thrive

One of the unintended consequences of the Fed’s actions, especially after the financial crisis, has been enabling companies with very weak balance sheets to survive. With interest rates low and so many institutions and investors reaching for yield, weak companies have been able to issue more debt, just so these Zombie firms can keep their doors open. A firm qualifies as a Zombie if it is at least ten years old and its profits are only enough to cover ongoing expenses i.e. wages, rent, interest expense on its debt, but doesn’t have enough cash flow to pay down debt or invest in their business for three consecutive years.

After rising modestly after the 2001 recession, the number of Zombie firms increased sharply after the financial crisis. According to Deutsche Bank in 2020 18.9% of U.S. firms meet the Zombie definition, and employ more than 2.2 million workers according to Arbor Data Science.

Although keeping Zombie firms open may protect 2.2 million jobs, it comes with a price for the overall economy. Since Zombie firms don’t have the cash flow to invest in new products, their growth is stunted and their workers are not adding to overall productivity growth within the U.S. economy. Zombie firms are the definition of dead weight and the ongoing increase in their number is not a good sign for the U.S. economy.

The Federal Reserve can’t choose which corporate bonds it will or won’t buy, but the Fed’s buying has lifted all boats. The consequence of keeping rates so low through traditional monetary policy and Quantitative Easing contributed to the weak growth in productivity since 2007, and could continue to hamper any improvement as the number of Zombie firms grows.

There are many factors that contribute to productivity but the increase in Zombie firms is a development the U.S. has ever had to deal with. Recessions serve the purpose of weeding out weak companies and the burden of their debt, so the strongest companies can prosper when economic growth returns after a recession. Austrian economist Joseph Schumpeter coined the term ‘creative destruction’, which he defined as

“the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”

In order for a dynamic economy to thrive it must be allowed to shed those companies that can’t contribute to change and productivity. Hiking to the top of a steep hill with an extra 20 pounds is not much different than competing in a global economy with almost 20% of the firms in the U.S. being dead weight.

High Corporate Leverage

Monetary policy accommodation has allowed more firms to increase their leverage since it’s cheaper to sell bonds than to issue stock. In fact many companies have increased their debt levels in order to buy back their stock in the past decade. Buybacks averaged $731 billion in 2017, 2018, and 2019. In 2020 buybacks have dropped as companies decided that in the middle of a Pandemic it’s wise to hoard cash.

As a percent of their market cap through mid August, U.S. companies have used buybacks to shrink their market cap by 1.08% compared to 0.72% in 2009 and 2.71% in 2019. In the 13 of the past 15 years companies have reduced their market caps by 3.0% to 5.0% through buybacks. By redcuing the number of outstanding shares corporations have lifted their earnings per share, even as many increased their leverag

A good determination of how levered a corporation may be is to determine how much cash flow they have relative to their debt, since corporations will service their debt from cash flow. Net cash flow is earnings before adjustments for interest, taxes, depreciation and amortization (EBITDA). The ratio of debt to EBITDA illustrates how much cash flow a company has to service its debt and the level of its leverage. The more levered corporations are the more difficult it will be for them to service their debt, especially during a recession. At the end of 2019 the leverage ratio for small cap stocks as measured by the Russell 2000 was higher than at any time since 1986. The ratio for the non-financial S&P 500 companies at the end of 2019 was much lower than the Russell 2000’s ratio. However, comparisons can be deceiving since the ratio was the highest since 1993 and higher than in 2009. The only time it has been above its current level was during the 2001 recession, which hit businesses much harder than consumers.

Corporations have increased their indebtedness because they have been able to roll over debt at ever lower interest rates, even lower rated firms. The increased leverage in the corporate sector exposes a vulnerability should interest rates rise, which puts the economy at a greater risk of defaults during a prolonged period of slow growth.

This risk is most obvious in small cap firms since 42% of the companies within the Russell 2000 don’t have any earnings, compared to 13% of companies in the S&P 500. Small cap stocks have been underperforming large cap stocks for a long time and this is clearly one reason, besides investor’s infatuation with Mega Cap growth stocks.

The Fed Goes Negative with Rates

In order to crush inflation Fed Chair Paul Volker increased the federal funds rate to 20.0% in 1981, and well above inflation, as shown by the Trimmed Mean PCE (TMPCE) Inflation Rate from the Federal Reserve of Dallas. Even after the TMPCE had fallen from 10% to 4% in 1983, the Federal Reserve maintained the federal funds rate comfortably above inflation.

The difference between the TMPCE and the federal funds rate provides the ‘real’ federal funds rate. In January 2002 the real fed funds rate fell below the TMPCE so the real fed funds rate was below zero percent. A negative fed funds rate is another symptom of extreme monetary accommodation.

The fed funds rate remained negative until March 2005 and became progressively positive as the FOMC increased the fed funds rate at 17 consecutive meetings from 1.0% in June 2004 to 5.25% in July 2006. As the housing market soured in early 2008, the FOMC lowered the fed funds rate aggressively and pushed it below the TMPCE in March 2008.

The fed funds rate held below the TMPCE until December 2018 after the FOMC increased the funds rate to 2.4%. In response to the COVID-19 Pandemic the FOMC slashed the federal funds rate to 0.13% and more than 1.25% below the TMPCE.

On August 27, 2020 Fed Chair Powell announced that the Federal Reserve will keep the federal funds rate below the rate of inflation until the Core PCE is comfortably above 2.0% for a period of time, which the FOMC has not defined.

By keeping the real federal funds rate below zero percent, the FOMC has lowered the real cost of funding for consumers, business, and the government, which has been supportive of economic growth. Consumer spending represents 70% of GDP so maintaining a negative fed funds rate has lifted housing prices and stock prices.

By targeting asset prices the FOMC expected consumer spending to increase, as the wealth effect from higher asset prices kicked in. Since January 2002 the federal funds rate has been negative in 16 of the past 18 years, and asset prices have indeed climbed significantly. Unfortunately, the FOMC’s policy has magnified the level of wealth inequality since 2002, and more so since the financial crisis.

The bottom 50% of Americans have far more exposure to the housing market so they suffered a larger drawdown than wealthy Americans, whose real estate losses were quickly offset by gains in the stock market. As of March 31, 2020 the top 10% of wage earners owned 87% of stocks, up modestly from the level in January 2002.

Monetary Policy Has Increased Wealth & Income Inequality

In 2018 the top 20% of families made 52% of all U.S. income. One of the prime drivers of income inequality is the earnings of the CEO’s of public companies and especially the CEO’s of S&P 500 firms.

According to the Economic Policy Institute (EPI) the average total compensation for a CEO was $14.8 million in 2019, while the median compensation was $13.1 million according to Executive Paywatch.

According to the Census Bureau median household income in 2019 was $68,703. The median wage for a full time worker was $19.33 per hour or roughly $40,000 per annum, according to the Economic Policy Institute. In 2019 the average CEO of an S&P 500 company earned 370 times the median hourly worker, and 215 times the income for the median household.

Many households have more than one worker and if a second earner was added to half of all households, adjusted median household income would fall to $45,802. The average CEO of an S&P 500 company would have earned 323 times the adjusted median income per household. If the median CEO income of $13.1 million is used, the ratios fall to 327 times the median hourly worker and 286 times adjusted median household income. In the 1960’s, 1970’s, and 1980’s, the ratios were never above 61.4 times the average worker’s income.

The level of income inequality really began to widen in the 1990’s after the Business Roundtable changed its Mission Statement to focus on Maximizing Shareholder value, and the technology bull market kicked into high gear. In 1997 the mission statement of the Business Roundtable stated that the principle objective of a business enterprise “is to generate economic returns to its owners” and if “the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.”

This marked a significant change from what the Mission Statement had been since 1981:

“Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment to continue and enhance the enterprise, provide jobs, and build the economy. The long term viability of the corporation depends upon its responsibility to the society of which it is a part. And the well being of society depends upon profitable and responsible business enterprises.”

The shift in emphasis from an enterprise to provide jobs that contribute to the well being of society in 1981 to a far narrower focus to generate economic returns to its owners in 1997 contributed a surge in stock option related income.

Stock Options Fuel Executive Compensation

In a perfect example of unintended consequences Congress passed a law in 1993 prohibiting companies from deducting yearly compensation of more than $1 million for any of their top five officers. In 1994, the first year the law was in effect, the value of option grants to CEO’s at S&P 500 firms leapt by 45% on average, and nearly doubled again over the next two years. From 1992 to 2001, the average value of option grants to CEO’s of S&P 500 companies soared nearly tenfold.

Of the $14.1 million the average CEO received in 2019, just $1.11 million was salary (7.89%), but $9.15 million was paid in stock and option awards (65%). There is clearly an income and wealth inequality issue in the U.S. that has been fueled by how executives are compensated. The Business Roundtable updated and changed its Mission Statement in 2019, but a substantive change of how executives are compensated would mean a lot more. If corporations don’t voluntarily change the amount and how their executives are paid, it may be done for them in the next 4 years.

Monetary Policy Veers off Course

On the evening of December 5, 1996 Fed Chair Alan Greenspan gave a speech to the American Enterprise Institute and referenced the valuation of the stock market:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

On December 5, 1996, the S&P 500 closed at 744 and didn’t reach the peak of exuberance until March 24, 2000 when it topped at 1553, 108% higher. A chastised Greenspan decided that the Federal Reserve shouldn’t attempt to prevent a bubble in equity prices by tightening monetary policy which could negatively impact the economy.

The Federal Reserve could have chosen to increase margin requirements for stock purchases, rather than increasing interest rates. This targeted approach would have lessened the mania without directly impacting the economy. Instead, the Fed chose a different path as Chair Greenspan expressed in a speech at the Meeting of the American Economic Association on January 3, 2004 entitled ‘Risk and Uncertainty in Monetary Policy‘:

“It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization–the very outcomes we would be seeking to avoid. Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion’.”

In response to the deflating of the dot.com bubble and the September 11, 2001 terrorist attack, the Fed lowered the fed funds rate below inflation in January 2002 and maintained it below inflation until March 2005.

There is little question that keeping rates so low for so long contributed to the housing bubble that ensued, along with a number of other major factors not related to monetary policy. In order to deal with the financial crisis in 2008 the Federal Reserve lowered the fed funds rate into negative territory and was forced to implement Quantitative Easing to push down long term rates.

Between 2008 and 2014 the Fed expanded its balance sheet from $700 billion to $4.1 trillion. In response to the COVID-19 Pandemic the Federal Reserve lowered the fed funds rate below zero percent and condensed 6 years of earlier Quantitative Easing into 3 months, as the Fed expanded its balance sheet from $4 trillion to $7 trillion.

When these measures proved insufficient the Fed purchased municipal bonds and corporate bonds including high yield bonds for the first time in history, and back stopped Treasury loans to small main street companies. Until a proven vaccine becomes widely available, Congress will provide additional support for millions of unemployed workers and funds for small and large companies most directly impacted, including airlines, hotels, restaurants, bars, and any business than relies on face to face contact. The Federal Reserve can be expected to expand its balance sheet further to accommodate more deficit spending in 2021 and beyond.

Almost Free Federal Debt

Since 2008 federal public debt has soared from $5.8 trillion to $16.8 trillion in 2019. Despite a 290% increase in debt since 2008, interest expense only rose by $122 billion or 48%.

This was made possible by the Federal Reserve’s combination of Quantitative Easing, which lowered long term Treasury yields and a low federal funds rate for most of the past decade.

Since the Federal Reserve expanded its balance sheet with the purchase of Treasury offerings, it has sent most of the interest it received from holding Treasury paper to the Treasury Department. These remittances have further reduced the annual interest expense for the government.

The amount declined from $116 billion in 2016, as the Federal Reserve increased the federal funds rate from 0.13% in December 2015 to 2.40% in December 2019. As the funds rate increased the Fed had to pay banks more for their reserves held at the Fed, which lowered the net proceeds of the Fed’s Treasury holdings. With the federal funds rate back at 0.13% in 2020 and the Fed’s increased holdings of Treasury paper, the annual remittance to the Treasury will rise significantly.

The chart by CRFB.org was created before the COVID-19 crisis, so the figures for 2020 and beyond are not accurate. It is possible that the amount of the Fed’s payment to the Treasury will exceed $80 billion in 2020 and $100 billion in 2021, significantly lowering interest expense. As of September 30, 2020 the Federal Reserve owned $4.44 trillion of Treasury securities, which amounts to 20% of total public federal debt. Effectively, 20% of outstanding public debt is being funded for virtually nothing.

In 1981 the public debt to GDP ratio in the U.S. was 31% and will exceed 100% in 2021. Contrary to economic orthodoxy, interest rates haven’t gone up and the increase in government debt didn’t crowd out corporate borrowing. In fact, interest rates for Treasury debt and corporate bonds are the lowest in history.

Some might assume that this trend will continue but the bond market has been known to throw a tantrum and the Federal Reserve has proclaimed that it not only wants inflation to increase to 2.0%, but will accept inflation holding above 2.0% for a period of time. Given the excess slack in the labor market (high unemployment) and production (low capacity utilization rate) in the U.S. and globally, the odds of the Fed achieving success soon are low.

However, that could change if an effective vaccine appears and allows for a full return to normal business activity that unleashes an outburst of spending by pent up consumers and rehiring by businesses.

Yield Curve Control

If Treasury yields rise due to an increase in inflation or a reluctance to buy Treasury bonds with a negative real yield, the Fed has an answer for that outcome too – Yield Curve Control (YCC). As the Treasury issued debt to fund World War II, the Federal Reserve increased its holdings of Treasury securities from $2.25 billion in 1942 to $24.26 billion when the war ended in 1945.

The Fed also capped the interest rate for 90-day Tbills at 0.375%, 2.0% for 10-year Treasury bonds, and 2.50% for the 20-year Treasury bond. After the war ended the Fed gradually phased out the interest rate caps starting with T-bills on July 3, 1947, with the caps on longer dated Treasury bonds ending in March 1951.

Although Federal Public debt as a percent of GDP is as high as it was in 1946, Total Market Credit Debt, which includes non financial corporate debt, household debt, and all levels of government debt, is up to 414% of GDP as of June 30, 2020 up from 129% in 1951.

The high level of total debt will leave the FOMC no choice but to implement YCC should Treasury yields rise too much, since an increase in debt servicing costs will prove too much of a head wind for the U.S. economy. The interest rate caps would likely be less on Treasury bonds than those used during World War II.

Monetary Policy Can Destroy Free Markets

Free markets provide the valuable function of price discovery as buyers and sellers incorporate demand and supply to establish the value of any security. The Federal Reserve’s intentional manipulation of the credit market since 2002 has progressively undermined the role of the market is establish a free market based level for interest rates in the Treasury bond market.

With the Fed’s decision in March 2020 to intervene in the corporate bond market, high yield bond market, and municipal bond market, the Fed has extended its reach and further eroded one of the primary purposes of a free market. Many valuation models use Treasury yields to determine how expensive or cheap stocks are, so the suppression of Treasury yields extends the Federal Reserve’s manipulation to stocks, even if they never buy a share.

In early 2018 the Federal Reserve began to shrink its balance by not buying new Treasury bonds and mortgage backed securities as existing holdings matured. A that time the Fed Chair Janet Yellen said the process would “run in the background” and be “like watching paint dry.”

However, after the Fed’s balance sheet had fallen from $4.4 trillion at the end of 2017 to $3.76 trillion in September 2019, liquidity problems developed in overnight funding for the repo market. In mid September the liquidity issues flared and the overnight repo rate, which normally tracks the federal funds rate closely, soared from 2.4% to briefly near 10.0%. To address this liquidity problem the FOMC injected liquidity by resuming its purchases of Treasury securities, which quickly increased the Fed’s balance sheet.

The Fed Checks into the Hotel California

Since 2002 the Federal Reserve has had to rely far less on its most important conventional monetary policy tool (interest rates), and progressively more on nonconventional actions, notably negative interest rates, Quantitative Easing, and the purchase of non government securities. The difficulty and inability to modestly shrink its balance sheet in 2018 and 2019 suggests that monetary policy has gone beyond the point of no return.

Circumstances and politics will lead the FOMC to continue to expand the Fed’s balance sheet in coming years. The concept of Modern Monetary Theory (MMT) is discussed as if it is something that may happen in the future. The evolution of monetary policy since 2002 and how the Fed has used its balance sheet during the Pandemic indicates that MMT is already in place.

The Federal government can run huge deficits knowing the Federal Reserve will be the buyer of first resort. And after remitting the interest income the Fed has received back to the Treasury, keep the government’s borrowing costs extremely low. Politicians won’t be able to resist spending more to address all of the U.S.’s special needs. So funding $1 trillion for an infrastructure program or funding a modest $3 trillion Universal Basic Income program to narrow the income inequality gap could easily be on the table.

According to the Congressional Budget Office (CBO), funding for the Highway Trust Fund will be depleted in 2021, the Medicare Hospital Insurance Trust Fund Part A will run out of money in fiscal 2024, the Social Security Disability Trust fund in fiscal 2026, and Social Security could run dry in 2032 or sooner.

It is unlikely politicians will vote to lower disbursements for these trust funds, especially for Medicare and Social Security, nor will tax increases prove sufficient since they would be too steep for the economy to bear. Politicians are likely to turn to the Federal Reserve to keep funding these programs. The Fed will learn that sometime around 2002 the Fed checked into the Hotel California of extreme monetary accommodation will never be able to leave.