Who will influence the world's most important interest rates? Bessenet "seizes power" from Powell

The U.S. Treasury Department is inclined to increase the issuance of short-term bonds, which is substantially undermining the independence of the Federal Reserve, and the authority to formulate monetary policy may effectively shift to the Treasury Department.

This week, U.S. Treasury Secretary Janet Yellen clearly stated a preference for relying more on short-term debt financing, a position that contrasts with her previous criticism of her predecessor's excessive reliance on short-term government bonds. This strategy is essentially equivalent to a fiscal version of quantitative easing.

In the short term, the Treasury's shift towards issuing more short-term government bonds will stimulate risk asset prices to further deviate from long-term fair value and structurally raise inflation levels.

The more profound impact is that this will severely limit the Federal Reserve's ability to independently formulate anti-inflation monetary policy, creating a fiscally dominant pattern. The actual independence of the Federal Reserve has been eroded in recent years, and the surge in short-term government bond issuance will further deprive the central bank of the space to freely formulate monetary policy.

Why Short-Term Bonds Are an "Accelerator" of Inflation

In the coming years, rising inflation seems inevitable, and the U.S. Treasury's decision to increase the issuance of short-term bonds is likely to become a structural factor driving inflation.

Treasury bills, as debt instruments with maturities of less than one year, are more "monetary" than long-term bonds. Historical data shows that fluctuations in the proportion of Treasury bills in the total outstanding debt often lead long-term inflation trends, resembling a causal relationship rather than a simple correlation.

The onset of the current inflation cycle was preceded by a rebound in Treasury bill issuance that began in the mid-2010s, when the U.S. fiscal deficit first experienced pro-cyclical growth.

Additionally, the explosive growth of the repurchase market in recent years has amplified the impact of short-term bonds. Due to improvements in the clearing mechanism and increased liquidity, repurchase transactions themselves have become more like money.

Treasury bills typically achieve zero haircut in repurchase transactions, allowing for higher leverage. These government bonds activated through repurchase are no longer dormant assets on balance sheets but are transformed into "quasi-money" that can drive up asset prices.

Moreover, the choice of issuance strategy has distinctly different impacts on market liquidity.

A striking example is that when the annual net bond issuance relative to the fiscal deficit is too high, the stock market often encounters trouble. The stock market fell into a bear market in 2022, prompting then-Treasury Secretary Yellen to release a large amount of Treasury bills in 2023. This move successfully guided money market funds to utilize the Federal Reserve's reverse repurchase agreement (RRP) tool to purchase these short-term bonds, injecting liquidity into the market and driving a stock market recovery.

Furthermore, observations show that the issuance of short-term Treasury bills is usually positively correlated with the growth of Federal Reserve reserves, especially after the pandemic; while the issuance of long-term bonds is negatively correlated with reserves In short, issuing more long-term debt will squeeze liquidity, while issuing more short-term debt will increase liquidity.

Issuing short-term debt provides the market with a "sweet stimulus," but when the stock market is at historical highs, investor positions are crowded, and valuations are extremely high, the effectiveness of this stimulus may be difficult to sustain.

The Era of "Fiscal Dominance" Has Arrived, and the Federal Reserve Is in a Dilemma

For the Federal Reserve, the irrational boom in asset prices and high consumer inflation, combined with a large amount of outstanding short-term debt, constitutes a tricky policy dilemma.

By convention, the central bank should adopt a tightening policy in response to this situation.

However, in an economy piled with a large amount of short-term debt, raising interest rates will almost immediately translate into fiscal tightening, as the government's borrowing costs will soar.

At that time, both the Federal Reserve and the Treasury will face immense pressure to loosen policies to offset the impact. In any case, the ultimate winner will be inflation.

As the outstanding balance of short-term Treasury bonds rises, the Federal Reserve will be constrained in raising interest rates, becoming increasingly unable to fulfill its complete mission. Instead, the government's massive deficit and its issuance plans will substantially dominate monetary policy, creating a fiscal dominance situation.

The market's accustomed independence of monetary policy will be significantly undermined, and this is still the case before the next Federal Reserve chair takes office, who is likely to lean towards the White House's ultra-dovish stance.

It is worth noting that this shift will have profound long-term implications for the market. First, the dollar will become a victim. Second, as the weighted average maturity of government debt shortens, the yield curve will tend to steepen, meaning that long-term financing costs will become more expensive.

To artificially suppress long-term yields, the likelihood of reactivating policy tools such as quantitative easing, yield curve control (YCC), and financial repression will greatly increase. Ultimately, this could become a "victory" for the Treasury.

If inflation is high enough and the government can manage to control its basic budget deficit, then the debt-to-GDP ratio may indeed decline. But for the Federal Reserve, this is undoubtedly a painful loss, as its hard-won independence will suffer severe erosion.