US Debt 'Double Whammy' Unsettles Emerging Markets
Writing in the Financial Times in June, India’s central bank governor Urjit Patel complained of the destabilizing effects of a U.S. debt “double whammy”: The Federal Reserve is ramping up its “balance sheet normalization” effort at just the moment when the U.S. budget deficit has been widening due to previously unanticipated tax cuts and higher levels of federal spending. The result, according to Patel, has been a diversion of significant amounts of available global capital away from emerging market economies and into the purchase of U.S. Treasury securities. This, in turn, pushes down the value of emerging market sovereign debt instruments and increases inflationary pressures. He urges the Fed to make a course correction.
Patel may have a point. Since election day in November 2017, the yield on 10-year Treasury bonds has risen from 2.307 percent to 2.862 percent, and the dollar has strengthened against many emerging market currencies. India’s rupee has fallen more than 6 percent relative to the dollar since October last year. The currencies of Argentina, Brazil, and Turkey have each fallen by more than 20 percent relative to the dollar over the past six months.
It is possible to estimate the potential size of the double whammy from the Fed’s publicly released plans for downsizing its balance sheet and from budget projections issued by the Congressional Budget Office (CBO).
Between November 2008 and October 2014, the Fed engaged in a series of purchases, known as quantitative easing (QE), that expanded its balance sheet from $0.9 trillion in 2008 to $4.5 trillion in 2014. During this period, the Fed bought $2 trillion of U.S. Treasury securities, or roughly 35 percent of the cumulative federal budget deficit during this period. The Fed also purchased $1.8 trillion of mortgage-backed securities (MBS) issued by Fannie Mae and Freddie Mac. The Fed halted QE at the end of 2014, but kept the aggregate value of its holdings steady by reinvesting the principal value of all of its maturing bonds. In October 2017, the Fed owned about 18 percent of all outstanding federal debt.
The Fed announced last year that it would begin reducing its holdings of Treasury and MBS securities over the next several years by not reinvesting a portion of the principal of maturing debt. Starting in October 2017, the Fed established caps limiting the amount of balance sheet “runoff” that would occur each month. To put it another way, only the principal amounts of maturing debt above the level of the monthly caps are reinvested in new purchases.
The monthly caps have been gradually increasing each quarter. From October 2017 to December 2017, the monthly caps were set at $6 billion and $4 billion for Treasury and MBS securities, respectively. The cap for Treasury securities was raised to $12 billion monthly beginning in January, to $18 billion in April, and to $24 billion in July. The last increase, to $30 billion monthly, is planned for September. The monthly cap for MBS securities is being raised in a similar fashion; it will reach $20 billion monthly in September. In some months, the amount of maturing debt will be less than the caps, which means the amount of balance sheet reduction that will occur in those months will be less than the cap would allow.
It is unlikely that the Fed will attempt to shrink its balance sheet all the way back to pre-financial crisis levels. Rather, the consensus among investors and others seems to be that the Fed’s goal is to reduce its assets to between $2.5 trillion and $3.5 trillion over several years.
In one bank’s model of how this might play out, the median scenario would have the Fed balance sheet falling to $2.9 trillion at the end of 2021 — a reduction of $1.6 trillion over four years. If the reduction in Fed ownership of Treasury securities is roughly in proportion to its current portfolio, then this model would imply the Fed would shed about $0.9 trillion in Treasury debt over this period.
The other half of the double whammy is the deteriorating budget outlook. In June 2017, before the tax cut and before Congress and the president agreed to large spending increases on appropriated accounts, CBO projected the cumulative deficit over the period 2018 to 2021 would be $2.9 trillion. CBO’s most recent forecast expects the deficit during these four years will reach $3.9 trillion, or $1 trillion more than was projected one year ago.
Taken together, then, the Fed is on course to reduce its holdings of Treasury securities by around $0.9 trillion over the next four years. Meanwhile, the federal government is expected to issue an additional $1 trillion in previously unanticipated federal debt over the same period. That’s a total of $1.9 trillion, or an average of $475 billion annually, in new Treasury securities above and beyond the baseline level of a $2.9 trillion federal deficit projected by CBO just last year. Flooding public markets with this much additional federal debt is bound to draw available capital away from other uses, including investments in emerging market economies. The drop in Fed holdings of MBS securities will compound the problem.
The irony, of course, is that the U.S. economy is stronger than it has been in some time, with low unemployment, low inflation, and improving prospects for workers who have not seen large wage gains in many years. This is the moment when the federal government should be restraining spending and reducing projected deficits, to free up resources for other, more productive uses. Instead, the federal government is now running large and widening deficits, with no end in sight, which only increases the pressure on the Fed to pursue an even tighter monetary policy.
If the turbulence that is hitting emerging markets is indeed related to a combination of a shifting Fed position on asset holdings and a deterioration in the U.S. fiscal outlook (which is not completely clear at this point, given the many complex factors involved), there may not be any easy answers. The Trump administration seems unaware and unconcerned about the risks its fiscal policy might create for the global economy, and the Fed wants to capitalize on a strong U.S. economy to turn the page on quantitative easing. Consequently, the pleas coming in from around the world are not likely to have much effect in Washington.
James C. Capretta is a RealClearPolicy Contributor and a resident fellow at the American Enterprise Institute.
