Bring them on. Financial Repression has a huge cost.
By Wolf Richter for WOLF STREET.
Yields have been rising in anticipation of a tightening cycle, and they will rise further when the Fed actually raises rates and engages in quantitative tightening (QT). Rising yields reduce bond prices for investors who sell those bonds. Investors that hold bonds to maturity earn the yield at which they purchased the security, and at maturity they get paid face value. A few hedge funds might blow up along the way because their highly leveraged bets went awry. So for current bondholders, a tightening cycle is not pretty.
But for future bond buyers and for savers, a whole new world opens up: a world with more income. And this higher income will throw off more tax revenues for governments. So how much money are we talking about here? $67 trillion in assets that will generate higher incomes.
There has been a lot of talk how the Fed can never raise interest rates because of x,y, and z, and how the Fed can never do QT because of x,y, and z. And one of the reasons often cited is that the US government wouldn’t be able to afford the higher interest payments. But that’s a red herring.
First, the US government issues its own currency and can always pay for anything with the Fed’s newly created money. The Federal Reserve Board of Governors, of which Powell is Chair Pro Tempore, is an agency of the US government. So the US won’t ever run out of money, but the dollar might run out of purchasing power – the trade-off that is now particularly ugly.
Second, only newly-issued Treasury securities would carry the higher coupon interest rate, and the still outstanding Treasury securities would continue to pay the same coupon interest as before. The higher rates would only show up when securities mature and are replaced by new securities, and as deficit spending is funded with new securities. So higher interest rates would only gradually filter into actual interest expenses for the government.
Third, and this is the topic here because no one ever mentions it: higher interest rates generate higher income across the entire Fixed Income spectrum, and higher income generates higher tax revenues.
Total “Fixed Income” Spectrum: $67 trillion.
There were nearly $54 trillion in US-issued bonds that were publicly traded at the end of 2021. This does not include bank loans, and it does not include the Treasury securities that are held by US government pension funds and by the Social Security Trust Fund (source of data: Sifma, US Treasury Dept.).
| US issued publicly traded bonds | Trillion $ |
| Treasury Securities, portion held by the public | 23.1 |
| Mortgage-backed securities | 12.0 |
| Corporate bonds | 10.0 |
| Municipal securities | 4.0 |
| Federal Agency securities | 2.0 |
| Asset-backed securities | 1.5 |
| Money Market | 1.1 |
| Total publicly traded bonds | 53.7 |
And deposits… There are about $18 trillion in deposits at commercial banks and credit unions. About $5 trillion are demand deposits, such as checking accounts. But around $13 trillion are deposits that in normal times carry interest, such as savings accounts and CDs.
Combined, the $53.7 trillion in publicly traded bonds and the $13 trillion in savings products make up the spectrum of “Fixed Income.” But that “fixed income” – the cash flow from regular interest payments – has gotten brutally crushed and sacrificed by the Fed on the altar of asset price inflation, as that whole range of investors, from life insurers to retirees and savers can attest to.
So about $67 trillion total investments would gradually begin to generate higher interest income as interest rates rise. And that income would generate income taxes for the federal government.
In other words, if some day in the future, the Federal government had to pay an interest rate that is 3 percentage points higher on average on its public debt, the entire and much larger fixed income spectrum would pay out about 3 percentage points higher interest rates, and recipients pay taxes on this additional income.
In addition, there are the secondary effects: Fixed income investors have gotten crushed when the cash flows from their investments went to near-zero. Many of them cut back their spending in response. Higher interest incomes across the Fixed Income spectrum would fuel more spending by the recipients – many of whom, such as retirees, would spend every dime they get – and this economic activity would generate more income, and more tax revenues.
Crushing the huge Fixed Income spectrum through the Fed’s financial repression was a really, really bad idea for numerous reasons – including the consequences on real economic activity. This started during the Financial Crisis with QE, and except for a feeble respite in 2018 and 2019, continues through today.
Obviously, when interest rates rise beyond a certain level, they begin to impact the economy in the other direction more strongly than higher interest income boosts spending and supports the economy – and the cooling-down process that the Fed is now planning begins.
When we look at the interest expense of the government, we should look at tax revenues triggered by the whole Fixed Income spectrum. That’s not how budget analysis works, but that’s how reality works. In other words: bring on those higher interest rates!
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