Where are we getting all this money?
That’s the question I’ve heard over and over since COVID-19 caused the deepest recession since the 1930s. So far this year, Federal stimulus programs and lower tax receipts have increased the outstanding Federal debt by $3.4 trillion, from $23.2 to $26.6 trillion.
In this article, I will try to answer the question. I will also briefly comment on economic and investment implications of 2020’s monetary and fiscal stimulus programs.
Coordinated Monetary & Fiscal Policy
Federal Reserve Chair Jay Powell puts it well when he says the Federal Reserve “has lending powers, not spending powers… our elected representatives… wield powers of taxation and spending.” The accompanying table details what Congress, through Fiscal Policy, and the Federal Reserve, through Monetary Policy, have done with those powers so far in 2020.
So, Congress decided to spend $2.4 trillion thus far to combat COVID and the recession.
The Federal Reserve, in pursuing its goals of full employment and stable prices, is implementing unlimited quantitative easing.
How do these programs work together? Let’s walk through the mechanics. For simplicity, I am going to ignore some of the sticky legal issues involved with these transactions.
To begin, let’s take a look at both sides of the Federal Reserve’s balance sheet.
A lot of attention is paid to the ‘asset’ side of the Fed’s balance sheet. But, the ‘liability’ side is just as important. Indeed, the Federal Reserve acts as a ‘bank for banks’ as well as being the bank for the US Treasury.
So far this year, quantitative easing and emergency lending programs have increased the Fed’s assets by $2.8 trillion, primarily through holdings of US Treasuries & Agency Mortgage-Backed Securities. On the liability side, bank reserves are up $1.2 trillion, the US Treasury General account is up $1.2 trillion, and currency in circulation is up $0.2 trillion.
Following the Money – 3 Transactions with 4 Participants
There are four players involved in the flow of funds when the Federal government borrows & spends.
- The US Treasury
- The Federal Reserve
- The US Banking System
- The Non-Banking Private System
How does 2020 deficit spending & quantitative easing impact these entities? Let’s follow the money.
In April, the US Treasury raised a record amount of money, $1.4 trillion, through the issuance of Treasury Bills, Notes & Bonds. Let’s examine the impact of that transaction on our four players.
Transaction #1 – US Treasury raises funds by issuing US Treasury Bonds
Here, banking system reserves are drained as the private sector trades their bank deposits for US Treasuries.
Also in April, the Federal Reserve increased its holdings of US Treasury Securities by roughly $1 trillion.
Transaction #2 – Federal Reserve purchases $1 trillion of US Treasury Securities via Quantitative Easing
Here, banking system reserves are partially replenished as the Federal Reserve injects deposits into the banking system in exchange for US treasuries sold by the nonbanking sector.
Finally, in April, the federal government ran a $740 billion deficit.
Transaction #3 – Federal government runs a $740 billion deficit
Net it all together, and what do you get?
Net Result of Transactions 1-3:
Voila! You have what’s commonly known as “money printing.” $340 billion in new cash deposits of the private sector, held through the US banking system as banking reserves at the Federal Reserve.
Also, take note, these sets of transactions did not necessarily require either (1) raising taxes, or (2) borrowing from a foreign government. The Federal government, unlike the rest of us, is able to create more US dollars when it needs them.
When that $1.4 trillion Treasury Bond becomes due in the future, the government can repeat this same set of transactions without ever necessarily needing to raise taxes. The tradeoff is that they may spur inflation or may impact the value of the US Dollar vs. other currencies.
Looking Forward – the Trillion-Dollar Question
Here is the trillion-dollar question. What will happen with the increased banking system reserves? They are likely to go even higher in the short term.
The US Treasury currently holds a record $1.6 trillion in deposits at the Federal Reserve. As Congress implements more deficit spending, those reserves will be converted to banking sector reserves, likely taking banking system reserve balances held at the Fed somewhere near $4 trillion.
Many people believe that inflation will be a natural, inevitable, consequence of this confluence of accommodative fiscal and monetary policy. While we believe consumer price inflation may happen, it depends heavily on whether the funds are spent or saved.
Remember, a similar set of policy tools was enacted after the financial crisis. From 2009-2020, the US experienced its longest expansion in recorded history, 10 years and 8 months. The unemployment rate fell all the way to 3.5%. Outstanding federal debt grew from $11.9 trillion to $23.2 trillion.
In that entire time, inflation only averaged 1.77% per year, below the Fed’s 2% target. Money supply, measured by M2, grew at about 6% per year. So, money growth, and greater federal debt levels, do not necessarily lead to inflation.
What has happened recently, however, is that the price of financial assets has increased. Interest rates have fallen to record lows. Stock market valuations are elevated relative to history. Home prices are at record highs. We refer to this phenomenon as ‘asset price inflation’. To us, it indicates that, so far, money has primarily remained in the form of savings.
Could we experience consumer goods inflation? Undoubtedly. Inflation has indeed picked up slightly in certain categories where supply has been constrained by the coronavirus. However, we agree with the Federal Reserve in their assessment that the COVID shock more likely to be disinflationary, as slack in the labor market and goods-producing sectors of the economy is likely to remain elevated in the coming years and the Federal government is already balking at additional fiscal stimulus.
We will continue to monitor these developments closely and will take action to align client portfolios with our outlooks for the economy and inflation. Thank you for your patronage during these interesting times. Please contact a member of your client centric team if you would like to discuss these ideas further.