Why the Fed pivot is giving Treasury heartburn

From: POLITICO's Morning Money - Monday Jan 24,2022 01:27 pm

Jan 24, 2022

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The Federal Reserve’s rapid pivot toward a faster pace of policy tightening has sent Treasury Department officials scrambling to rewrite their borrowing roadmap for 2022. That could mean lots more Treasury debt hitting the market later this year and next, much sooner than officials anticipated.

After a torrent of government borrowing in 2020 and 2021 to counter the fallout from the pandemic, the Treasury is in the middle of what was supposed to be an orderly process of scaling back debt issuance as federal deficits continue to decline. Once Congress raised the debt limit in December after a months-long showdown, the beginning of 2022 was supposed to give them a bit of breathing room to plan.

“The general view was that over a period of three calendar quarters, the Treasury would have a very steady ramp-down in auction sizes,” said Lou Crandall, chief economist at Wrightson ICAP LLC.

Then along came the Fed.

Central bank officials are expected to signal at their meeting this week that they will raise interest rates in March, and markets predict three more hikes could follow later this year.

Fed Chair Jerome Powell and other central bank officials have also suggested they may move soon after that to start shrinking their nearly $9 trillion portfolio of assets by allowing Treasury securities to mature without reinvesting them. Policy analysts expect the process, which would help fight inflation by effectively tightening financial conditions, could start as early as this summer.

Why does that matter to the Treasury? The simplest way to think about it, says Crandall, is that for every dollar of Treasury securities the Fed allows to roll off its balance sheet, the Treasury has to increase the size of its public debt auctions by a dollar.

That means the shrinking balance sheet is going to require larger Treasury auction sizes than we otherwise would have had, testing investor appetite for U.S. debt.

How much larger? That depends on how quickly the Fed allows its balance sheet to shrink. Last time, officials capped the runoff of Treasury and mortgage-backed securities at $10 billion a month initially, then slowly increased the monthly cap to $50 billion. Some officials have said they’d like to see a much more aggressive approach this time.

Meanwhile, “there’s still so many other uncertainties in the fiscal outlook” — the fate of Build Back Better, the path of government spending and revenues amid the Omicron surge — “that the poor Treasury is faced with a much more complicated early 2022 outlook than it anticipated,” Crandall tells MM.

Treasury officials will have only a few days to digest the Fed’s policy signals this week before releasing new details of their borrowing plans for the coming quarters on Feb. 2.

Enough about the balance sheet, what about interest rates?

Treasury is on track to spend $5.4 trillion on net interest payments over the next decade, the Congressional Budget Office estimated in July. A small rise in rates could mean hundreds of billions more in borrowing costs over that time.

With almost all of our borrowing fixed in nominal terms, higher inflation will help inflate away some of the debt, said Jason Furman, who chaired the Council of Economic Advisers during the Obama administration. Still, the Treasury is especially vulnerable to rising rates now because its borrowing is very short-term.

How to mitigate that problem? Furman says the Treasury should consider issuing more longer-term debt. Because borrowing longer would drive up long-term interest rates, such a move now could also help rein in inflation.

“It would be like an equivalent of quantitative tightening happening out of the Treasury,” Furman said. “I don’t think they should do it in order to control inflation, but it would have a side effect.”

Would the big banks that buy Treasury debt go for it? Crandall is skeptical. But he said the idea does speak to the changing dynamics between monetary and fiscal policy.

“For years the standard description was, fiscal policy did what it was going to do, and monetary policy — because it was more nimble — responded,” he said.

“Now we’re at a point where, with the Fed being a dominant player in the Treasury market, the Treasury is having to respond to the Fed, because the Fed is actively altering the Treasury’s financing requirements,” he added. “And we just don’t have a good model for how that runs in reverse.”

IT’S MONDAY — Another month, another Fed meeting. Let us know what you think reporters should ask Powell at his press conference this week and we’ll publish the best ones.

And please, as always, send us your tips, ideas and general feedback: kdavidson@politico.com, aweaver@politico.com, or on Twitter @katedavidson or @aubreeeweaver.

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Driving the Week

SEC Chair Gary Gensler delivers keynote address at Securities Regulation Institute virtual conference Monday … Federal Open Market Committee begins its two-day meeting Tuesday … SEC holds meeting by teleconference to consider amendments to reporting requirements Wednesday …

Acting FHFA Director Sandra Thompson speaks at a virtual discussion hosted by Women in Housing and Finance Wednesday … Fed releases policy statement and Powell holds press conference Wednesday … Commerce Department releases fourth-quarter GDP data and durable goods data Thursday … Commerce releases December consumer spending and PCE inflation data Friday … University of Michigan releases consumer sentiment data Friday.

DEMOCRATS SLIM DOWN AMBITIONS AFTER BACK-TO-BACK FAILURES — Our Burgess Everett and Marianne LeVine: “There’s little appetite in the Democratic majority to publicly fall shorton high-profile priorities so soon after the party’s failures to both weaken the filibuster to pass election reform and to approve President Joe Biden’s $1.7 trillion social spending bill. Instead, many Democrats are itching to get back to voting on bills that have plenty of GOP support, such as a new deal to fund the government or changing antitrust laws.”

BIDEN UPS PRESSURE ON HOUSE TO PASS CHIPS FUNDING IN CHINA BILL — Our Gavin Bade and Steven Overly: “President Joe Biden reiterated his call on Friday for Congress to pass tens of billions of dollars in funding for domestic microchip production, saying the long-delayed bill would push companies to build new chip factories like a $20 billion facility being planned in Ohio.”

IRS SENDING SOME TAXPAYERS ERRONEOUS CHILD TAX CREDIT INFO — Our Aaron Lorenzo: “Many taxpayers are receiving IRS letters with incorrect child tax credit amounts just before they’re supposed to start filing their tax returns.

“In these cases, which could involve hundreds of thousands to millions of people by some estimates, figures printed on IRS correspondence meant to serve as a guide don’t match what people received in their bank accounts for the expanded credit in 2021, causing uncertainty about what the IRS has on record.”

Yikes: Your MM host spoke last week with Deputy Treasury Secretary Wally Adeyemo, who said the letters were one of the ways that Treasury was trying to get ahead of what’s expected to be a turbulent filing season.

As Aaron reports, “mismatches with IRS records could trigger excess processing and review times, erroneous refund amounts and even hold up refunds – something most taxpayers count on.”

WHITE HOUSE IS SET TO PUT ITSELF AT CENTER OF U.S. CRYPTO POLICY — Bloomberg’s Jennifer Epstein, Jenny Leonard and Allyson Versprille: “The Biden administration is preparing to release an initial government-wide strategy for digital assets as soon as next month and task federal agencies with assessing the risks and opportunities that they pose, according to people familiar with the matter.

“Senior administration officials have held multiple meetings on the plan, which is being drafted as an executive order, said the people. The directive, which would be presented to President Joe Biden in the coming weeks, puts the White House at the center of Washington’s efforts to deal with cryptocurrencies.”

RAPID INFLATION FUELS DEBATE OVER WHAT’S TO BLAME: PANDEMIC OR POLICY — NYT’s Jeanna Smialek and Ana Swanson: “The price increases bedeviling consumers, businesses and policymakers worldwide have prompted a heated debate in Washington about how much of today’s rapid inflation is a result of policy choices in the United States and how much stems from global factors tied to the pandemic, like snarled supply chains.”

—FWIW: From researchers at BlackRock’s Investment Institute: “Fiscal policy cannot explain why inflation is so high when economic activity has yet to fully recover. The fundamental constraint is that supply capacity is unusually low. This is yet another way in which this restart differs from a normal cyclical recovery.”

FED WATCH

—WSJ’s Nick Timiraos: “A faster pace of rate rises later this year could call for increasing rates at consecutive policy meetings, which are scheduled roughly every six weeks—something the Fed hasn’t done since 2006.”

—Here’s a look at how the U.S. stock market has fared historically when the Fed begins tightening rates, from Bloomberg’s Jess Menton.

—Reuters’ David Randall: “Expectations of rising interest rates are bolstering the shares of regional banks , as a tumble in technology stocks pushes investors to search for assets that could thrive amid higher yields and tighter Federal Reserve policy.”

FIRST LOOK: PROGRESSIVES TARGET TOOMEY ON FED NOMINEES — Progressive group Battle Born Collective plans to circulate a memo on Capitol Hill today questioning Sen. Pat Toomey’s (R-Pa.) credibility on Federal Reserve nominees, and pointing to his “past support of nominees with fringe views and meager qualifications.” Specifically, they cite his support for Trump Fed nominees Stephen Moore and Judy Shelton, who failed to win enough support from Senate Republicans to win confirmation.

Toomey has said he plans to examine the nominees “qualifications,” and a GOP aide told MM last week the issue will likely come up during nomination hearings.

Jobs Report

Moira Vahey has joined Plaid, where she will lead policy communications. Vahey worked most recently as communications director at the Student Borrowing Protection Center, and previously served as a fintech advisor and agency spokesperson at the Consumer Financial Protection Bureau.

FLY AROUND

U.S. FOOD SUPPLY IS UNDER PRESSURE, FROM PLANTS TO STORE SHELVES — WSJ’s Jesse Newman and Jaewon Kang: “The U.S. food system is under renewed strain as Covid-19’s Omicron variant stretches workforces from processing plants to grocery stores, leaving gaps on supermarket shelves. … Food-industry executives and analysts warn that the situation could persist for weeks or months, even as the current wave of Covid-19 infections eases.”

CHINA’S SUCCESS TAMING VIRUS COULD MAKE EXIT STRATEGY HARDER — AP’s Aniruddha Ghosal and Huizhong Wu: “The sweeping ‘zero-tolerance’ strategy that China has used to keep COVID-19 case numbers low and its economy functioning may, paradoxically, make it harder for the country to exit the pandemic.

“T[]the uncompromising approach also means most people in China have never been exposed to the virus. At the same time, the effectiveness of China’s most widely used vaccines has been called into question. … Together, those factors could complicate China’s effort to get past the pandemic.”

WORLD BANK UNDER PRESSURE TO RELEASE AFGHAN FUNDS — FT’s Andrew Jack, Benjamin Parkin and Fazelminallah Qazizai: “Leading charities working in Afghanistan are demanding that the World Bank and its key shareholders release more than $1.2bn in frozen funds to pay teachers and other government workers and prevent the collapse of essential services.

“Save the Children is among the organisations launching a public petition, and calls on officials this week to release money beyond humanitarian assistance to sectors including education and health, as a Taliban delegation opens talks in Norway.”

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