The US Budget Deficit Is Worrisome, Dudley Says

I care very much about the auctions, as everyone knows. I also care about the deficit. Even if people say that it doesn't matter. There is this issue of is it just something people can put in the backs of their minds and say it hasn't mattered for 30 years? It's not going to probably matter going forward without maybe just a blip here and there. Why should somebody be paying so close, such close attention to this? Even if these auctions are going off without a hitch, reasons #1 unsustainable trends always have to come to an end. So we know that this can't go on indefinitely #2 the situation is bad and it's probably going to get worse. The Congressional Budget Office assumptions are actually pretty optimistic. They don't have a recession in their forecast over the next 10 years. They assume that the tax cuts that were enacted in 2017 expire, so that flatters the deficit. So things are probably going to be even worse. The other thing I think it's important to recognize here is that when things go bad, they go bad quickly because if people start to balk and and don't want to buy take on the increased supply of Treasury securities, interest rates go up, at least the higher debt service costs, at least the higher deficit. So the feedback loop here is really can be quite vicious. The hard thing is to know timing. You know, it's not clear exactly why the bond market vigilantes were arrived exactly when they arrived in the mid 1990s, and it's not clear when they'll arrive this time. But this is not a great trajectory. The other thing I think is important here to realize is that we don't have quite the same demand for Treasuries internationally than we did before because of sanctions. The countries that are not friends of the US are trying to diversify their holdings of foreign exchange reserves out of Treasury because they're worried that sanctions can be evoked sometime in the future. So the good news is the dollar is still the reserve currency. The dollar is probably going to be the reserve currency for, you know, several decades at least. But that exorbitant privilege that was once called doesn't necessarily have to last forever. Bill, you raised a fascinating point that I want to dig into. You raised a lot of fascinating points, but one just to unpack this idea that if you do see any kind of fumble in the demand for Treasuries and yields go higher, it becomes almost this spiraling effect that's going to create bigger overall debt servicing costs for the government, which is going to deepen the deficit, which is going to make people even more nervous about buying Treasuries. Do we have a sense of what the debt servicing costs look like if rates stay where they are now, say, if they don't go down or if you get volatility and rate structure and volatility and inflation, but the Fed is not able to cut rates significantly to levels that we previously saw without igniting true inflation, which calls our hand. Well, that's one of the big problems we have right now. We're rolling all over all the, all the debt that was issued in, you know, the last 10-15 years at very low rates, at much higher rates. And so the debt service costs are going to go up much more rapidly than the total amount of debt. We, we were very flattered by what happened between 2008 and 2022. The level of debt roughly tripled. Debt service costs went up by something on the order of 20 to 30%. So the situation's not going to reverse. That's going to get debt service costs are going to go much faster than the total amount of debt bill. I can't help but wonder if, when and if it happens if it is more brutal than the 90s. And the reason I ask that is we learn the lesson with the UK that part of the turmoil sparked from non banking entities. It was LDI, it was pension funds. Debt has shifted away into other hands beyond the banks. So if we do get some sort of rapid sell off in a post regulatory GFC environment, are banks prepared to help act as a ballast as potentially they once did in those types of sell offs? Well, I'm not sure that anybody wants to come into a market and catch the following night. Things are really bad. I mean, clearly the capacity of the primary dealers to, you know, provide support to the treasury market in size is obviously much diminished relative to the total size of the treasury market. So the idea that somehow bank dealers can come in and sort of support the market, you know, I think you have to view that as limited. Now obviously the primary dealer community has to show up at the auctions and the Fed is you know pretty focused on making sure that none of the auctions fail. But the but a non failure of the auction doesn't mean that necessarily the markets subdued. You could see a lot longer tails higher yields on auctions relative to existing securities and so things could get out of hand very, very quickly. I know you said that this is not possible to time, but Bill, do you think this all just translates to any sort of duration appetite right now has a cap just because simply this threat exists? Well, I think you know what the outcome of the election might be relevant here, right? Right now, we don't know who the next president's going to be. And you know, it's it's very clear that from published reports that the Trump administration is pretty hostile to the Federal Reserve. So you can imagine a situation where if you had a Trump presidency and it was trying to very much limit the independence of the Fed, people could start to be worried about the inflation outlook, that the Fed would be pressured into sort of monetizing debt. And the reality is when debt levels are really high and rising very quickly, there's lots of temptation to allow higher inflation because higher inflation then devalues the debt. We actually saw that during the pandemic. The surge of inflation that we had during the pandemic actually caused the debt to GDP ratio in the United States to decline despite large budget deficits. So monetizing the debt is is sort of always one way out. It's a horrible way out. And you're basically confiscating the value of the of the debt that people hold but through inflation. But that's always a temptation and people start to worry about that. And I think the worries about that would be much higher under a Trump administration than a Biden administration because of Trump's hostility to the Fed. That could also be an exacerbating factor. A lot of people talk about what independent FED would look like with Trump as presidency because of this Wall Street Journal article. But when it comes to the responsibility of the Federal Reserve that's delegated by Congress, what could he actually do? Do you think legally do that would hurt the independence of the Fed? Well, I think it's as you as you're, as you're implying it's a lot harder to to change the independence of the Fed than just saying that you want to to do it. The governor's terms are staggered 1 Governor's term tours every two years. The Federal Reserve presidents that sit on the Federal Open Market Committee are appointed by their board of directors and the Federal Reserve Board, not by the president not confirmed by the Senate. So taking control of the Fed is is quite, quite difficult. That said, just the mere attempt to take control of the Fed to diminish the Feds independence, you know, could be the spark that rattles markets when it comes to the deficit. Do you have thoughts regarding who you think would actually be worse for the fiscal trajectory of the US? You know, it's I, I don't think either side has, you know, distinguished themselves, the Trump administration or the Biden administration. I think that the difference between the two though, I think is if you, if you have a second Biden administration, I think you know what you're getting in terms of policy. So the risk in terms of policy uncertainty is a lot less than under a Trump administration. You know, Trump has proposed some already. The proposals coming out of the Trump side are, are pretty extreme, you know, dramatically raising tariffs, cutting income taxes and corporate income taxes. You know, that would be very inflationary in itself. So, so we have we, you know, we had a Trump administration and if he did what he says he's going to do, and of course, there's always a question about that, you know, the, the, the economic environment, I think would be a lot more volatile and a lot more uncertain. Bill, before I let you go, since you were on the Fed and you did have a prominent role in the Fed, can you give us a sense of what the conversations are probably like about not 2024 in the path of rates, but the lack of visibility into 2025 given the uncertainty that you just highlighted? I think the Fed takes the world as it is. So in my, in my experience, they, they don't worry about like election outcomes that are going to happen down the road. They react once the election outcome occurs. And that leads to a set of policies that are relevant for monetary policy. So the Fed's not going to do something, you know, preemptively or not do something preemptively because of concerns about what the election outcome would be. They'll set the policy based on, you know, what's happening to growth, what's happening to inflation. And I think right now, I mean, markets, you know, trying to figure out what the Fed's going to be next. And it's pretty difficult because it's very much data dependent. Weaker economy, better inflation is the Fed cuts, stronger economy, not so good inflation new the Fed stays on hold. And the reality is there's, you know, the data has been pretty mixed.