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The Federal Reserve faces a series of complex policy decisions as it grapples with the mounting concerns among investors regarding the United States government’s colossal $33.5 trillion debt. This anxiety about America’s fiscal future has already led to an unexpected increase in US bond yields, prompting policymakers to consider postponing planned interest-rate hikes.
Wall Street’s unease over the US budgetary challenges presents risks on both sides of the central bank’s dual mandate. On one hand, the apprehension regarding deficits and debt exerts upward pressure on long-term interest rates, potentially stalling economic growth and increasing unemployment. Simultaneously, it can fuel higher inflation, especially if the Fed appears to downplay its commitment to price stability to control the government’s borrowing costs.
Former Fed Governor Kevin Warsh, who advised President George W. Bush, noted, “We are witnessing the beginning of a regime change in how investors perceive America’s fiscal sustainability.”
However, it’s important to recognize that there are other factors contributing to the decline in bond prices, which has driven the yield on the benchmark 10-year Treasury note to 4.83% from this year’s low of 3.31% on April 6. Chief among these is the US economy’s resilience in the face of the most extensive credit-tightening campaign by the Fed in decades.
Fed Chair Jerome Powell is expected to offer his perspective during an appearance before the Economic Club of New York. Observers anticipate that he will implicitly support a growing consensus among policymakers that the higher yields might provide an opportunity to maintain the current policy at their upcoming meeting as they evaluate the economic outlook. However, given that inflation remains above the Fed’s 2% target, Powell may suggest the possibility of a rate increase later in the year.
Economists from Bloomberg suggest that the recent surge in 10-year Treasury yields will have a dampening effect on economic growth, akin to a Fed rate hike. This increase, if sustained, is estimated to reduce the need for a 50-basis point interest rate reduction.
Former Fed Vice Chair Donald Kohn and other experts argue that Powell and his colleagues should communicate more openly about the impact of fiscal policy on the economy, interest rates, and the central bank. They believe this would enhance the public’s understanding of the consequences for monetary policy and the economy.
It’s been widely acknowledged for some time that the federal budget’s trajectory is unsustainable, with soaring debt levels. Recent events, including the downgrade of the US credit rating by Fitch Ratings Inc. and a larger-than-expected quarterly borrowing requirement by the Treasury, have brought these concerns to the forefront. A recent estimate by the Congressional Budget Office, revealing a more than 20% increase in the deficit for the just-ended fiscal year, has heightened unease.
While the administration maintains its commitment to reducing the budget shortfall, concerns persist. Many investors are worried about diminishing demand for Treasury securities, fearing that China and Japan, the two largest foreign holders of US debt, will reduce their purchases. The Fed itself is gradually reducing its bond holdings through a process known as quantitative tightening, which is expected to continue even as they reduce interest rates next year.
The increase in yields poses a threat to an already precarious fiscal outlook, according to former CBO Director Douglas Holtz-Eakin. He emphasizes that the US budget is highly sensitive to interest rates, and if the bond market accurately reflects the fiscal position, it could spell trouble. Warsh concurs, stating, “It’s exceedingly difficult to have sound monetary policy without sound fiscal policy, and US fiscal policy is decidedly unsound.
