Debt Death Spirals, Fed's Losses, & Fiscal Theory Of Price Level | Peter Stella & Joseph Wang
What this covers
Peter Stella, Former Head of the IMF Central Banking Division, joins Joseph Wang, former senior trader for the New York Fed and author at Fedguy.com, and Jack Farley for a wide-ranging discussion on:
-what really causes inflation -monetarism, fiscal theory of the price level, and modern monetary theory (MMT) -the unrealized losses on the Fed’s balance sheet -why yield curve control likely won’t be necessary (or so Peter argues) -the longer the duration of a governments’ debt, the less inflation is required to inflate it away -when a central bank incurs unrealized losses, who “wins” and who “loses”?
Filmed on March 29, 2023. ____ Follow Joseph Wang on Twitter https://twitter.com/FedGuy12 Joseph Wang’s writings: https://fedguy.com/ Joseph’s latest piece, “Ameridollars”: https://fedguy.com/ameridollars/ Peter Stella on Twitter: https://twitter.com/Stellar_Consult Peter Stella’s work: https://www.centralbankarchaeology.com/ “Do Central Banks Need Capital?” by Peter Stella: https://www.imf.org/en/Publications/WP/Issues/2016/12/30/Do-Central-Banks-Need-Capital-2260
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Market commentary, charts, degen trade ideas, governance updates, token performance, can’t-miss-tweets and more. Subscribe to the Blockworks Research “Daily Debrief” Newsletter: https://rb.gy/feusos ____ Timestamps:
00:00 Intro 00:15 Peter Stella's Background At The International Monetary Fund (IMF) 03:55 Joseph Wang On The Flaws Of Monetarism 05:52 Milton Friedman: It's The Government That Prints Money 07:56 The Fiscal Theory Of The Price Level 13:38 Modern Monetary Theory (MMT) 24:12 Real Value Of U.S. Debt Is Lower Now Than March 2020 37:33 Permissionless 38:38 The Fed Has Huge Unrealized Losses On Its Balance Sheet 45:29 Details About The Fed's Mortgage-Backed Securities (MBS) Purchases In 2020 51:51 Did The Fed Help Wealthy Homeowners Refinance Their Mortgages In 2020? 54:21 Blockworks Research Plug 55:22 When The Federal Reserve Has Unrealied Losses On Its Balance Sheets, Who Loses and Who Gains? 01:13:50 Joseph Wang's Summary Of This Conversation 01:15:08 Yield Curve Control and Potential Debt Death Spiral ____ Disclaimer: Nothing discussed on Forward Guidance should be considered as investment advice. Please always do your own research & speak to a financial advisor before thinking about, thinking about putting your money into these crazy markets.
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Stella and Wang argue that inflation is fundamentally a fiscal phenomenon determined by the government's debt and deficit dynamics, not primarily a monetary one, and that the Federal Reserve's massive balance sheet expansion—particularly in mortgage-backed securities—had significant distributional consequences that were fiscal in nature despite being executed by an independent central bank.
- The quantity theory of money breaks down when governments can finance deficits through domestic debt markets; what matters is the total stock of government liabilities (money + bonds), not their composition
- The COVID fiscal shock was absorbed with moderate inflation because the US had a large domestic debt market and shock-absorbing financial system, whereas countries without this infrastructure face immediate inflation
- Fed MBS purchases during 2020-2021 functionally constituted fiscal transfers to wealthy homeowners at taxpayer expense, with $400B in losses that contrasted with Treasury gains, revealing the fiscal nature of monetary operations
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Before the 2008 global financial crisis, the Federal Reserve's balance sheet contained only about $20 billion in bank reserves despite the banking system functioning normally, demonstrating that the supply of central bank money was demand-determined, not supply-determined; people who wanted physical dollars could get them at a price
“before the balance sheet expansion so if we take the fed's balance sheet in 2008 the amount of currency and circulation was about 800 billion dollars maybe the amount the amount of of reserves Bank Reserves people probably have trouble believing this but it was 20 billion dollars”
Countries that developed domestic debt markets—including Chile, Peru, Mexico, Israel, Brazil—transformed from a state of 'original sin' (inability to issue debt in their own currency) in the 1980s to having significant domestic debt markets by the 2010s, enabling them to issue debt during the COVID crisis at low rates without sparking inflation or currency crises
“countries like Chile Peru Mexico Israel if you looked in the 1980s when I was traveling to Argentina there was no domestic debt Market we used to call this or the market used to call this original sin they could not issue debt in their own currency because they were always defaulting well if you look around now Peru Mexico Brazil Chile Israel they all have quite significant domestic debt markets”
The quantity theory of money was not actually wrong in historical contexts, but rather those contexts (fixed exchange rates, underdeveloped domestic debt markets) have been superseded by new institutional arrangements that change which variables drive inflation.
“and and I would say the fiscal theory is basically saying well it's still it's still right this is not a new idea it's still the government that's the driving force but now the government can Finance itself not only in the advanced countries but in many Emerging Markets now with domestic debt issuance in their own currency so what what does that mean it means basically if you will the government doesn't the government has a larger base of liabilities on which it can default through inflation”
Governments that lack credibility and reputation for fiscal responsibility will face much higher inflation and currency instability even at relatively low debt-to-GDP ratios, while credible governments can sustain high debt ratios with low inflation; the fiscal theory predicts this outcome because inflation expectations depend on whether markets believe the government will generate future primary surpluses
“you know I think if you look at the structures of the economies and and in my view again this issue of the development of the domestic debt Market uh has a lot to say but also about the reputation of the fiscal authorities uh whether they will be uh relatively responsible right”
Milton Friedman and John Maynard Keynes, in their popular writings on money printing, consistently described the government—not the central bank—as doing the printing; Friedman and Keynes were essentially describing a fiscal dominance scenario where the government forces the central bank to monetize deficits
“if you take a look at some of let's say one of Milton Friedman's more popular writings right mate for the general public it's called Uh money mistress almost every time that Friedman talks about money printing he says it's the government that prints money and I I don't think that's an accident I I don't think that's a mistake”
The demand for securities (bonds) in financial markets is fundamentally important for macroeconomic stability because it provides the 'lubrication' that allows financial markets to function; government debt serves as a benchmark for private corporate debt markets, expanding the ability to finance deficits without inflation
“the kind of fundamental demand for securities as the lubrication of what makes financial markets work and it's not only the government debt Market but private corporate markets feed on benchmarks established by the southern so that basically expands tremendously the cumulative deficits that you can Finance without inflation okay”
During the 2008 global financial crisis, US government securities produced the best asset returns despite the crisis originating in the US, because global investors rushed to safe-haven dollar assets, providing exceptional demand for Fed liabilities.
“the irony in in the whole you know the GFC was that although it originated in the U.S the best asset class return in I think 2009 2010 was the U.S government securities right so any other country if the crisis you know there's a crisis in in Mexico right they the Mexican value of the debt goes down and people don't want Mexican pesos right I mean it's it's very counterintuitive but in the U.S you know this Global crisis of people rushed and they're ready to finance you know they they're ready to finance the treasury they're ready to finance hold the FED hold the FED obligations”
Central bank independence is best maintained through a governance rule where governments do not criticize central banks and central banks do not criticize government officials, creating institutional separation despite fiscal interdependence.
“if you ask me again all of my experience says in many many countries you really have to be you know have a responsible government in place but you have an independent institution and the rules are government doesn't criticize us doesn't put us under political oppression so we don't criticize the government and we don't criticize uh you know the the government of officials um and that's kind of the rules and I I think that makes sense to a certain extent okay”
Yield curve control and similar tools have been used by major central banks (Japan, Australia) in the past, suggesting they are reasonable policy options that have gained acceptance.
“sometimes I don't know if we have clever people running the banks though so so uh so it seems like the path at least resistance it's already socialized in the marketplace so it's being used by big central banks like Japan and Australia in the past”
In Argentina in 1988-1989, monthly inflation reached 195.5% (not annualized), demonstrating that high inflation is a fiscal phenomenon driven by government deficits rather than central bank money printing alone, since the government lacked a domestic debt market and was forced to monetize spending directly
“I was in Argentina when inflation was 195.5 in one month that's not the annualized rate that's the monthly rate... and I think certainly well I think most people would agree at least by now that Argentina's problems are really fiscal problems”
If a price level jump occurred as predicted by fiscal theory following a major fiscal shock, prices cannot actually jump instantaneously because they are sticky; instead, inflation rises gradually over time due to the lags and inertia in how inflation is measured and how prices adjust
“coming back to reality as opposed to the theory price the price level cannot jump you know it's just statistically not possible so we will see inflation come up you know continue to increase if it is a if it is a result this physical phenomenon simply because of the sort of the inertia and the lags that are that are there in the inflation you know the way inflation is measured”
The Treasury successfully liquidated agency mortgage-backed securities from its balance sheet in 2010-2011 when the debt ceiling became binding, demonstrating that asset sales are operationally feasible even in stressed market conditions.
“when the debt ceiling started to bind in 2010 2011 under the Obama Administration do you know what happened the treasury auctioned off these mortgage-backed Securities and debt so if you say oh it's impossible to sell them uh I'm sorry if that limit happened so the fact that charity said well I need to sell these assets these private assets take the cash and use it you know to to spend because I can't issue more data to buy back debt”
During the COVID crisis, the Fed reached nearly 2 trillion dollars in Treasury holdings on its balance sheet while the Treasury was building up deposits at the Fed rather than immediately spending money, effectively providing outright monetary financing until Congress was ready and tax dates had been postponed.
“the treasury's balance that the FED reached almost two trillion dollars uh during the covet crisis so what does that mean that the treasury was issuing a lot of debt but it wasn't actually spending the money yet and so it was it was building up a huge huge deposit uh at the Fed so so that I think was you know that the FED in a sense provided outright monetary Finance”
The real limitation on the amount of losses the Federal Reserve can sustain is inflation: once cash flow imbalances force the Fed to effectively monetize its losses, at some point people stop expecting the Fed to maintain price stability and inflation expectations unanchor.
“so then I would say the question becomes at at what point does that cash flow imbalance um get to a situation where people say the FED has to inflate away it's on that right”
Joseph Wang emphasizes that when looking at inflation over recent years, one must consider both monetary policy AND fiscal policy; understanding inflation requires a fiscal lens rather than viewing monetary factors in isolation
“it's mostly fiscal so when we think about inflation over the part over the over the time it's not just about monetary policy it's not just about Central bank's balance sheet but we also have to focus on what the fiscal authorities are doing so what's the government debt for example how much are we spending”
Yield curve control (fixing interest rates at designated levels) was used by the US during World War II and the Korean War as a method to manage government debt without inflation spiraling.
“that's that's what we had during the second world war in the Korean War uh I think they're probably more clever ways to to solve that problem”
The housing market did not require additional Federal Reserve stimulus in 2021, as home prices were rising approximately 20% year-over-year, indicating an overheated market rather than one needing support.
“it really didn't make sense in 2021 it wasn't like uh 2009 when we had a real crisis in housing in 2021 our house prices were going up year over year about 20 so there's a tremendous tremendous boom in in house prices there's really no need for there to be additional stimulus”
During the Volcker era (early 1980s), the US Treasury was issuing 30-year bonds at 12-14% coupon rates; if inflation came down to single digits as intended, these bondholders would realize 12% real returns, which no country could sustainably finance and would require either inflation to stay high or fiscal primary surpluses that would be impossible to achieve
“I was an intern at the Federal Reserve in 1983. and at that time uh Paul volcker wasn't in power uh and the U.S treasury was issuing data I think 12 or 14 percent...so what I said at that time to some people at the FED I said it doesn't make sense if if if the government the treasury the Central Bank believes that we're going to bring inflation down to single digits or to two percent three percent why is the why is the treasury issuing 30-year bonds at 14”
Interest rates on Federal Reserve deposits and reverse repo facilities are now at approximately 5% or higher, whereas previously the Fed paid minimal rates on reserves.
“now the FED also paying interest on it at very high rates now remember before the great financial crisis the FED had a very small balance sheet and it really didn't matter what they were paying on interest but now they have a balance sheet of a few trillion and as interest rates go to five percent or more that that actually has pretty big fiscal implications as well right”
The Federal Reserve had $1.2 trillion in unrealized losses on its balance sheet as of 2022, consisting of approximately $800 billion in losses on Treasury holdings and $400 billion in losses on mortgage-backed security holdings
“the increase in unrealized losses during 2022 is 1.2 trillion dollars it's a lot of money it's a lot of money about 800 billion were the losses on the treasury portfolio 400 billion on the mortgage-backed security portfolio”
Renters bear the cost of Fed-enabled housing price inflation through rising rents, particularly in the latest CPI data showing rents rising at 8.8%, whereas homeowners benefit from asset appreciation.
“the latest CPI number the cost of renting a primary reversance was rising at 8.8 percent and again who are the renters in America by far they are uh you know the poor poor part of the population people without you know without assets and so on not everyone of course but right if you look at the demographics it's very clear who is paying the price for you know in terms of that inflationary like who's bearing the burden of the inflation it's not the homeowners you know house prices have gone up”
Federal Reserve balance sheet expansion during the global financial crisis—particularly mortgage-backed security purchases—was justified to prevent housing market collapse and deflation, but the Fed should have shrunk the balance sheet more aggressively and earlier starting in 2013-2014.
“I'm very supportive of the of the balance sheet expansion that happened after the global financial crisis particularly the in the mortgage-backed security area um you know I could go into that if if you want but I think the mortgage Market was in I mean the housing market was basically in free fall coming into the into 2008-2009 um House Shelter the shelter component of CPI went into deflation in 2009 uh 2010 and we also had mortgage rates were not that low in terms of when when you have deflation or zero inflation uh five percent mortgage rate might sound like it's not very high to old people like me but uh you know it's a five percent real one you have zero percent inflation um so what so I was in favor of that but I really felt that the Fed should have Shrunk the balance sheet sooner and much more dramatically than it did”
Silicon Valley Bank's balance sheet was heavily concentrated in agency mortgage-backed securities similar to those the Federal Reserve purchased, making it vulnerable to interest rate increases that eroded asset values.
“the a lot of the what was on Silicon Valley Banks balance sheet the bank that collapsed a little over two weeks ago was agency mortgage-backed Securities very similar if not the same to the assets that the Federal Reserve bought”
The Fed should have a governance structure that puts pressure on it to shrink its balance sheet when it is not needed, similar to how the Treasury faces pressure through the debt ceiling; without such constraints, the Fed's independence allows it to expand indefinitely without political accountability.
“we have to have some sort of we have to have some sort of governance structure that puts pressure on that entity to shrink the balance sheet when it doesn't need to”
The Fed's narrative about balance sheet normalization has consistently ratcheted expectations downward: starting with 'temporary, we'll get back to pre-crisis levels,' shifting to 'maybe not back to pre-crisis,' then to 'back to wherever it needs to be now,' and finally to keeping the balance sheet permanently enlarged.
“it just seems to me that you know the original increase was this is temporary we're going to get it back down to as soon as we can the amount that you know we're going to shrink it to the to where it was before then it then it kind of jumped up again and it became well we're gonna shrink it but maybe not right now and not back to where it was but where it needs to be now and it keeps just getting ratcheting up and up and up”
The market value of US government bonds has shifted from trading 8% above par (108) in March 2020 to trading 8% below par (92) in December 2022; however, these bonds will mature at par (100), so the current market losses are transitory and will be reversed as bonds approach maturity
“if you look at March 2020 basically the the ratio between the market value of U.S government debt and the par value was about 1.08 so it was about eight percent above par and now it's about eight percent below par in other words we've been surprised that by an increase in interest rates as you said Jack was suddenly interest rates went up and so you know the bond went from 108 to kind of 92.”
There is a tipping point for every country—determined by the demand for central bank liabilities and the demand for that country's currency—beyond which large central bank losses require either monetary financing (printing money) or inflation to service the debt; the United States is 'very far away' from this tipping point due to global demand for US dollar-denominated assets
“there is a Tipping Point for every country and the Tipping Point is can you finance the central bank's losses at a low rate of inflation okay so some of them it's absolutely not true uh now uh it's it's uh but if I could say it's a non-linear relationship in the empirics I have a paper on that”
During 2020-2021, the Federal Reserve's mortgage-backed security purchases functionally constituted a monetary transfer to wealthy homeowners: the Fed purchased MBS at high prices as homeowners refinanced into lower rates, with 44% of the Fed's MBS holdings issued in 2021 and a large portion bearing coupons of 2.5% or less, while the Fed will realize $400 billion in losses on these holdings when interest rates rose
“really a huge part of the fed's accumulation of MBS during that period was the reinvestment of prepayments on mortgages okay so uh in in at the end of 2021 44 of the fed's MBS Holdings were issued in 2021 okay and I think it was uh I have the number but it's it's some amazing amount of the fed's portfolio have coupons of 2.5 percent or less”
The COVID fiscal shock resulted in the US government issuing $4.4 trillion in new debt since March 2020, but the real market value of total US government debt is actually $400 billion lower in December 2022 than it was in March 2020, meaning that inflation and the rise in interest rates have effectively 'inflated away' all the new debt issued for COVID spending
“if you look at the real market value of U.S government that today or December of 2022 it's actually lower than it was in March of 2020. so the US government has issued about 4.4 trillion dollars worth of debt between since covet started but if you take the increase in the GDP deflator it's about 14 percent and the market prices and bonds have fallen the real market value of of U.S government that is about 400 billion dollars less than it was in uh March of 2020”
Central bank independence should be defined as the ability to raise interest rates even when the government doesn't want rates to be raised; governments, as large borrowers, always prefer low rates, so true independence means resisting political pressure to keep rates low despite fiscal concerns
“the way I've defined Central Bank Independence is the central bank is independent if it can raise interest rates when the government doesn't want it to raise interest rates and the answer is sort of the footnote to that is and governments never want the central banks because they're the big they're a big borrower right they don't want the rates to go up”
The Bush Administration's Housing Support Act of 2008 authorized the Treasury to purchase agency mortgage-backed securities, and this program was subject to Congressional oversight, political accountability, and limits on the amount that could be purchased; by contrast, the Federal Reserve's subsequent MBS purchases lacked these governance constraints and resulted in much larger positions with similar fiscal distributional consequences
“the treasury was doing what the FED later did but what was the difference the treasury or the government had to pass along it was political Heat by the opposition when they passed the law it's called the housing support Act of 2008...number one number two of course the uh amount that the treasury was allowed to do was specified in the law it wasn't an open-ended thing and of course Congress had to authorize uh the spending”
As interest rates rise and the Federal Reserve pays higher rates on deposits and reserves while collecting lower coupon payments from its portfolio, the Fed will face increasing pressure to either reduce its balance sheet, raise rates further (exacerbating losses), or finance the gap by expanding liabilities, with fiscal implications
“the FED is now running cash losses it started running cash losses in the last quarter right so it's paying five well eventually probably be paying five percent on its repo facility on all the deposits and it's not getting the uh uh you know the coupons the payments on the mortgage-backed securities and from the treasury so it's essentially going to have to print you know what we would call printing money”
If repeated shocks the size of the COVID shock were to occur, the US would eventually run into inflation problems as the fiscal adjustment capacity is exhausted; the current favorable outcome is partly a result of being able to absorb a large one-time shock, but repeated shocks would overwhelm the system
“but if a country were to have repeated shocks the size of covet you know that's that's when you then you would run into this you you would eventually run into the problem”
Joseph Wang's book 'Central Banking 101' and his essay 'Ameradollars' on fedguy.com provide accessible introductions to modern monetary theory and fiscal theory frameworks; Wang's work bridges between technical analysis and popular understanding
“everyone should check out um not only your book Joseph Central Banking 101 you have a piece on call on fakeguy.com called ameradollars which is about related to this mmt adjacent theory”