The US Treasury’s Backdoor Stimulus Is Hampering the Fed

Nouriel Roubini, a senior adviser at Hudson Bay Capital Management LP and Professor Emeritus at New York University’s Stern School of Business, is the author, most recently, of Megathreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them (Little, Brown and Company, 2022). He is a former senior adviser at the US Treasury (1999-2000). Stephen Miran, Senior Strategist at Hudson Bay Capital, is a former senior adviser at the US Treasury (2020-21).

NEW YORK – The US Federal Reserve has moved mountains to control inflation, which in July fell below 3% for the first time since 2021. Unfortunately, the Fed finds itself working at cross purposes with the US Treasury, whose debt-issuance strategy has been providing backdoor interest-rate cuts, keeping inflation above the Fed’s target range.

By shortening its issuance profile to reduce long-term interest rates, the Treasury has delivered economic stimulus equivalent to a one-point cut in the Fed’s policy rate. Moreover, forward guidance in the Treasury’s latest quarterly refunding announcement indicates that this backdoor quantitative easing (QE) will continue to frustrate the Fed’s own efforts and compromise its functions.

Typically, the Treasury aims for 15-20% of outstanding debt to be in short-term bills, with the rest in intermediate- and long-term debt, called coupons. But this share has risen and remains well above any reasonable threshold: as much as 70% of new debt raised over the last year came from short-term bills, pushing the total well above 20%.

Such an excessive reliance on short-term debt is generally reserved for times of war or recession, when markets are fragile and financing needs spike. Yet the past year has been one of buoyant equity markets, above-target inflation, and strong growth. Investors understandably have begun to question whether the Treasury’s issuance strategy is still “regular and predictable,” and lawmakers such as Senators Bill Hagerty and John Kennedy have taken notice and begun to confront Treasury Secretary Janet L. Yellen over the issue.

In a recent Hudson Bay Capital research paper, we describe the current policy as a case of “Activist Treasury Issuance” (ATI) and consider its broader economic consequences. Like activist monetary policy, activist issuance deviates from the standard rules and influences the broader economy through its effect on interest rates. Not only does the ATI work through the same channels as the Fed’s QE programs, but it was engineered in part by the former Fed officials who now run the Treasury.

Whereas bills are economically similar to the base money created by central banks, coupons bear significant interest-rate risk, and when investors must absorb more of this risk, they are less able to hold other risky assets like stocks. Thus, when the supply of bonds goes down, bond prices go up, and this pushes other asset markets higher through what economists call the “portfolio balance channel.”

While QE hides bonds away on the Fed’s balance sheet and gives investors money in their place, an ATI reduces the creation of bonds at the source, giving investors more “money-like bills” instead. The results are similar: lower yields and juiced-up asset prices stimulate the economy.

We calculate that ATI has so far reduced coupon issuance by more than $800 billion, delivering a degree of stimulus similar to that of a 100-basis-point reduction in the Fed’s policy rate. Put another way, the Treasury has effectively offset all the Fed’s 2023 interest-rate hikes. Not only that, but the ATI has been supplemented with forward guidance – another favorite Fed tool – indicating that it will persist for another few quarters, to the other side of this year’s US election.

Combined with higher estimates of so-called neutral policy rates, the current issuance and interest-rate policies mean that there is little restriction on the economy. With the Treasury blocking the Fed’s attempts to cool inflation and growth, it is little wonder that both metrics have remained persistently above target.

If the ATI is not quickly reversed, it may become a permanent policy tool, because both parties will want to use it to stimulate the economy ahead of elections. We will have entered a world of politicized business cycles, where policy stimulus is synchronized with the polls. This prospect is disturbing for the same reasons that threats to central-bank independence are.

To unwind its ATI, the Treasury will need to retire $1 trillion worth of excess bills. This would temporarily (for a few years) raise long-term yields by 0.5%, but these yields would ease to a permanent 0.3% rate, with an attendant repricing of risk assets. The cooling effect on the economy would be similar to that of a two-point hike in the Fed’s policy rate.

The Treasury’s activist issuance strategies have stimulated the economy in the run-up to an election and blocked the Fed’s own efforts to cool inflation. An ATI opens the door to political business cycles in which inflation and interest rates run permanently higher because the economy receives too much stimulus over time. The Treasury must return to regular and predictable issuance as quickly as possible.