Yields were 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 who hold bonds to maturity earn the yield at which they purchased the security, and at maturity they receive their face value. A few hedge funds might blow up along the way because their high leverage bets have gone bad. So for current bondholders, a tightening cycle is not pretty.
But for future bond buyers and savers, a whole new world is opening up: a world with more income. And this higher income will lead to more tax revenue for governments. So how much money are we talking about here? $67 trillion in assets that will generate higher income.
There’s been a lot of talk about 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 often cited reasons is that the US government would not be able to pay the higher interest. But it is a red herring.
First, the US government issues its own currency and can still pay for anything with the newly created money from the Fed. The Federal Reserve Board of Governors, of which Powell is chairman pro tempore, is an agency of the US government. So the United States will never 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 bear the higher coupon interest rate, and Treasury securities still outstanding would continue to pay the same coupon interest as before. The higher rates would only appear when the securities mature and are replaced by new securities, and when deficit expenditure is financed by new securities. Thus, higher interest rates would only gradually affect the government’s real interest expenditure.
Third, and this is the topic here because no one ever mentions it: higher interest rates generate higher income across the fixed income spectrum, and higher income generates tax revenue. higher.
Total “fixed income” spectrum: $67 trillion.
There were nearly $54 trillion of bonds issued in the United States that were listed on the stock exchange at the end of 2021. This does not include bank loans and does not include Treasury securities held by funds of US government pension and by the Social Security Trust Fund (data source: Sifma, US Treasury Department).
|Publicly listed bonds issued in the United States||trillion $|
|Treasury securities, share held by the public||23.1|
|Securities backed by mortgages||12.0|
|Federal Agency Titles||2.0|
|Total listed bonds||53.7|
And deposits… There are approximately $18 trillion in deposits in commercial banks and credit unions. About $5 trillion are demand deposits, such as checking accounts. But about $13 trillion are deposits that normally bear interest, such as savings accounts and CDs.
Together, the $53.7 trillion in publicly traded bonds and $13 trillion in savings products make up the “fixed income” spectrum. But this “fixed income” – the cash flow from regular interest payments – has been brutally crushed and sacrificed by the Fed on the altar of asset price inflation, as this whole range of investors, from life insurers to retirees and savers.
Thus, approximately $67 trillion in 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 someday in the future the federal government were to pay an average 3 percentage point higher interest rate on its public debt, the entire fixed income spectrum, and much more broad, would pay about 3 percentage points higher interest rates. , and the beneficiaries pay taxes on this additional income.
Plus, there are the side effects: fixed-income investors were crushed when cash flow from their investments went to near zero. Many of them have cut spending in response. Higher interest income across the fixed income spectrum would further fuel the spending of beneficiaries – many of whom, like retirees, would spend every penny they receive – and this economic activity would generate more income and more of tax revenue.
Crushing the massive specter of fixed income securities through Fed financial repression was a very, very bad idea for many reasons – including the consequences for real economic activity. It started during the financial crisis with QE and, except for a small respite in 2018 and 2019, continues until today.
Obviously, when interest rates rise beyond a certain level, they begin to have a stronger impact on the economy in the other direction as higher interest income stimulates spending and supports the economy – and the cooling process that the Fed now foresees begins.
When we look at government interest charges, we should be looking at the tax revenue generated by the full spectrum of fixed income securities. That’s not how budget analysis works, but that’s how reality works. In other words: bring in those higher interest rates!
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.