All fiscal policy decisions are determined by the Congress and the White House; the Fed plays no role there. Its remit is the Monetary Policy.
This often creates a conundrum for the Central Bank: how does it then really tackle inflationary headwinds that are offshoots of a loose Fiscal Policy?
There are many examples of US fiscal profligacy from the recent past: the Trump tax cuts of 2017 (the tax cuts were supposedly funded but turns out they were mostly financed by federal borrowing); the roughly $5 trillion dollar in pandemic stimulus money aka Helicopter Money; the $1.2 trillion spending infrastructure bill that Biden signed into law in 2021; and the $433 billion investment in the Inflation Reduction Act, 2022 (offers households rebates and incentives of up to $28,500 to install climate friendly household appliances and switch to electric cars)
Guess who pays for those government spends/rebates/subsidies/tax incentives?
Well, they ought to be supported by tax revenues but if the tax revenues come in lower than the spends, then you have a problem.
This is where the US Treasury steps in, issues USTs, and saves the day for the Government.
But what if the federal government does not rein in spending? What then?
Enter ‘The Bond Vigilantes’!
A Bond Vigilante (a word coined by Edward Yardeni) refers to a bond market investor who protests against monetary or fiscal policies considered inflationary by selling bonds, thus increasing yields.
The events that whipsawed the bond markets over the last few days have led to whispers that the Bond Vigilantes are back and are hemming in the US Treasury (in a close parallel to how the Gilt Markets torpedoed former UK chancellor Kwarteng’s GBP 45b package of unfunded tax cuts at about the same time last year).
The Fed Rate is an effective tool for determining monetary policy and reining in inflation, but the Bond Markets can bring things to a boil faster if they decide to play ‘activists en masse’ (Opinions vary with Bill Gross indicating, in a recent interview, that Bond Vigilantes will have a muted effect).
The ramifications in the bond markets play out across a much larger scale around the planet involving Banks, Insurance companies, Pension Funds, Corporate and Sovereign Debt Markets.
Insurance and Pension Funds buy bonds to hold them until maturity, but those portfolios may be upended in a situation where the Bond Vigilantes sell ahead of the pension funds, leaving the funds no choice but to sell out as well to meet collateral calls (These are the very sequence of events that played out in the UK last year when the yields on Gilts soared momentarily).
The events over the last few days have played out against the backdrop of a net treasury issuance in 2023 that is the second highest on record (after the pandemic) and in an environment where the biggest buyer of T-bonds, the Fed, has stepped back from the market as it continues its tightening program.
Something has to give!
