We saw yesterday the proposal of the Biden administration for the 2025 budget. The projected deficit is 6% of nominal GDP. This is the equivalent of 1.7 trillion dollars. The budget constraint says that there are two ways to fund a deficit:
1) increase the money base, and
2) increase the level of the debt.
We all know that option 1 can not take place while the Federal Reserve is shrinking the size of its balance sheet and is maybe willing -after the recent data- to keep interest rates higher for longer. What we are left with is option 2.
Funding a 1.7 trillion USD deficit by issuing short-term Treasury bills is the same as printing money but paying interest on it. We need to note here, that the Federal Reserve, through its policy of paying interest on banks’ reserves, is also paying interest on a big chunk of its liabilities. So why should treat the two liabilities differently?
When an investor buys Treasury bills, he or she can leverage the position by 95%. With the proceeds, this investor can buy stocks, bitcoins, real estate or just spend on consumption, knowing that the value of the Treasury bills will be eroded over time due to inflation. In other words, Treasury bills have become as liquid as money and respect the definitions of money.
The chart below depicts the YoY change in USD of the sum of the Federal Reserve liabilities and the amount of Treasury Bills outstanding. The amount of money that has been created since March 2023 -coinciding with the collapse of SVB- is a staggering 1.7 trillion dollars, enough to cover the whole deficit of 2024. This sum is about 70% of the amount of money created in the aftermath of the GFC. But unlike GFC, this avalanche of money is not being confined between a few banks and few funds but is spreading throughout the economy as the minimum amount to buy a Treasury bill is a mere 100 dollars. Every Joe can practically do this trade.
When a government starts funding its large deficits through short-term floating rate debt because it cannot tap the bond market, fearing a sharp rise in long-term yields, this government is simply printing the most dangerous form of money and it has taken over the management of the monetary policy.
The transmission mechanism of monetary policy works best when fiscal policy objectives are aligned with those of the monetary policy. If the Treasury Department is printing more money than the Fed is retiring, the outcome will be a loose policy setting and not a tight policy setting. From that angle, investors should be focusing much more on the developments in the market of T-bills than on the FOMC meetings.