On Wednesday, January 31st, the Federal Reserve decided to keep its policy-setting federal funds rate unchanged at 5.33%. This predictable decision puts the Fed on the path to lowering interest rates this spring, when inflation is down further and when the economy slows down.
I recently explained that there are hints of such a slowdown in the latest GDP data. My forecast is supported by the new assessment of the labor market from the ADP Research Institute, which shows a disappointing jobs number for January.
Unless there are new numbers between now and March that point in the opposite direction, I expect the Fed’s Open Market Committee to cut its federal funds rate at the March 19th meeting.
By keeping its interest rate unchanged, the Federal Reserve does its due diligence in preventing a rebound of inflation. Some people are concerned that this will happen—I don’t share their worry—but with the Fed’s steady hand on the monetary policy steering wheel, the risk for another high-inflation episode is minimal.
With the path opening to a rate cut in March, the Fed is also inspiring hope that the economic slowdown, when it comes, will be short and mild. Lower interest rates reduce credit costs for consumers and small businesses and allow homeowners to refinance high-rate mortgages. All of this will transform into a moderate but much-needed boost in private-sector activity over the second half of 2024.
There is just one caveat, and it is a big one: the deficit in the federal government’s budget. Borrowed money is now their biggest single revenue source, and there are no signs that this will change any time soon. The only two ideas for fiscal policy that are alive on Capitol Hill today, would make things worse, not better, if they were put to work.
One of them is Cato Institute fiscal analyst Romina Boccia’s dangerous idea of a bipartisan fiscal commission; the other is the package of tax hikes that Boccia’s commission would propose.
If the plans for tax increases move forward, with or without help from a Boccia commission, and if it looks like Congress may actually pass them, then interest rates will start rising. It does not take much for interest rates to rise; they have gone up recently, breaking with a trend of falling rates that began early last fall.
The federal government’s abysmal fiscal performance is undoubtedly a big factor behind this trend break. It also plays a role in whether or not the Federal Reserve will be able to cut its policy-setting rate in the spring. If there is no movement toward smaller budget deficits—never mind a balanced budget—the market for U.S. Treasury securities will become increasingly uneasy. By the time we get to March, we could very well see a sharp rise in the rates that investors demand in order to buy more U.S. debt. At that point, the Fed would have to consider rate increases rather than decreases.
This is an extreme scenario, but it cannot be ruled out. The absurd aspect of it is that Congress themselves have a vested interest in getting their budget in good order: if interest rates remain elevated, their borrowing costs will remain elevated as well. It will not take much to make interest on the debt the largest expense item in the federal budget.
Fortunately, there are some indications that the U.S. Treasury is finally taking action to mitigate its borrowing costs:
The Treasury Department on Wednesday will likely make the final increase in the amount of longer-dated bonds it seeks to sell and stick with its mantra of being regular and predictable, following a couple of tumultuous years for the bond market.
This is a technical statement full of insider language. It means, plainly, that after two years of selling massive amounts of new debt under short-term securities—those that mature in one year or less—the Treasury is now going to try to sell more of their new debt under maturities that last for several years.
I have criticized the U.S. Treasury numerous times in the past for its choice to sell new debt under short-term securities. Since the fourth quarter of 2022, short-maturity Treasury securities have paid a higher interest rate than their long-term securities have. This is a so-called inverted yield curve; normally, investors get higher interest rates when they lend their money (which is technically what a Treasury security is) for longer terms than for shorter terms.
The inverted yield curve has remained in place for well over a year now; when the Treasury’s insistence on borrowing money on short terms is coupled with this inverted curve, it is easy to see that the Treasury has made U.S. debt unnecessarily expensive to taxpayers.
The good news, again, is that the Treasury finally decided to listen. In a press release on Wednesday, January 31st, the Treasury announces that it
plans to increase the auction sizes of the 2- and 5-year [notes] by $3 billion per month, the 3-year by $2 billion per month, and the 7-year by 1 billion per month. As a result, the auction sizes of the 2-, 3-, 5-, and 7-year will increase by $9 billion, $6 billion, $9 billion, and $3 billion, respectively, by the end of April 2024.
It remains to be seen if they will reduce the volume of debt sold under the shorter maturities, but I doubt they will. After all, the U.S. government is running budget deficits upward of $1.5 trillion per year. In addition to this new debt, it has to roll over existing debt as it matures; doing all of this by selling primarily long-term debt will be a major challenge for the Treasury. Nevertheless, the intention of selling more longer-term debt, late as it may be, is welcome; the Treasury deserves a chance to prove that they are doing their darndest to mitigate rising debt costs.
That said, there is only so much the Treasury can do. At the end of the day, the ball is in Congress’s court. They, and only they, have the power to end endless budget deficits.
