Every Federal Reserve Board meeting is second-guessed by the markets — and the latest is no exception. No one can deny the power of the Fed to impact the economy by increasing or cutting interest rates. But not even an informed group of experts can set the perfect rate to keep the economy moving on an even keel — not too hot and inflationary, not too slow and recessionary.
Like the Wizard of Oz behind the curtain, the all-powerful Fed likes to cultivate the illusion of power, while reality dictates the impossibility of their control. The laws of supply and demand will eventually set the market price (interest rates) on Treasury borrowings.
The Fed can distort the markets, but not forever. They artificially kept rates low — and now the economy is paying the price as financial institutions worry about balance sheets stuffed with low-yielding government securities. If they now — and we will only know in hindsight — keep rates too high, the result will show up in a different kind of economic distortion.
Fed policies are always “transitory” — because they have no superpowers to know for sure what will happen as a result of their actions. Only the free market can give a fair answer to the question of how high interest rates will go.
Supply
When the government borrows to finance its deficit, it creates a new supply of IOUs — Treasury bills, notes and bonds — that must be purchased by “someone.” That purchaser is typically the banks and financial institutions, foreign central banks, professional investors, and then the individuals who park their money in these securities for safety.
There are weekly auctions of short term T-bills (13- and 26-week maturities, predominantly) and regular monthly auctions of Treasury notes and bonds. The actual rate set at auction is determined by what the potential buyers demand to compensate for both inflation risk in holding those securities and any potential global political risk. Inflation risk pushes rates higher. Global risk typically pushes rates lower as money seeks the safest place in the world — traditionally, U.S. government IOUs.
Individuals who buy securities at those Treasury auctions agree to accept the average rate set by the big players, not knowing the specific rate in advance of the auction, though they are likely close to current rates in the trading market. (For details on how to buy Treasuries, check the article on the home page at TerrySavage.com.)
Demand
Working Lunch
The level of interest rates is also impacted by demand for these U.S. government IOUs from the U. S. government. In recent years, there was a huge extra demand for these IOUs from the Fed itself! It bought Treasury securities and paid for them with newly created liquidity. That liquidity helped keep interest rates down for a while.
Now the Fed is pretty much out of the bond-buying end of the market. In fact, they are regularly unloading the Treasury securities and other investments in their portfolio. They are no longer buyers, but have become sellers — in effect putting upward pressure on rates.
Foreign central banks have historically been big buyers of Treasury securities. As of September 2023, foreign countries held $7.4 trillion in Treasuries — or roughly 24% of total US debt. Japan is the largest holder at $1.1 trillion of U.S debt, and China comes in second, owning $821 trillion of our debt. We are indeed dependent in some part on the “kindness of strangers.”
Interest rates
The Fed isn’t the only force that creates higher rates. If foreign central banks, or others, decide to demand a higher rate in compensation for lending us money, the cost to the United States will be significant. For every one percentage point increase in rates on our national debt, the interest cost increases our debt by approximately $187 billion! The cost of interest on the national debt nearly doubled from 2020 to 2023, from $345 billion to $660 billion. And as we refinance old, lower-rate debt that cost could grow dramatically in the years ahead.
So, while the magic of Fed pronouncements dominates the headlines, the actions of the marketplace speak louder than words. If we don’t get our debt under control, we will pay the price. And that’s The Savage Truth.
(Terry Savage is a registered investment adviser and the author of four best-selling books, including “The Savage Truth on Money.” Terry responds to questions on her blog at TerrySavage.com.)
©2023 Terry Savage. Distributed by Tribune Content Agency, LLC.