Nov 27, 2017

Caroline Baum on Treasury Yield Curves and the Debt Ceiling

The Treasury yield curve is an important macroeconomic indicator to consider, and it may be a warning sign for future recessions.
David Beckworth Senior Research Fellow , Caroline Baum

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Caroline Baum is an economics columnist at MarketWatch and formerly was a writer for Bloomberg and Dow Jones. She joins Macro Musings to discuss how she became a financial journalist as a non-economics major as well as her recent columns on monetary policy and what Treasury bond yields are predicting about the future. She also shares her thoughts on why the debt ceiling should be abolished. Finally, Caroline and David discuss Jerome Powell and Fed leadership in the age of Trump.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to

David Beckworth: Caroline, welcome to the show.

Caroline Baum: I'm happy to be here, David. Thank you for having me.

Beckworth: Well, it's a treat to have you on. We've gotten to know each other over the recent years. Well, really since the crisis I think, we corresponded some and I've followed your writing before then, and you've been active, as I mentioned in the intro in business and economic journalism, but you have a background that takes you into monetarism. So, tell us about that.

Baum: I didn't study economics in school, and somehow, I call it the one-on-one class. I had all these great Friedman students willing to spend time on the phone, curious mind, interested in getting it right. So, I say to people, "I learn every day in my job, maybe even on Sunday sometime." It's what appealed to me. I studied that, things that made sense to me. I did go back to school then as I started writing about this in the late 80s to take macro, and micro, and money, and banking, but by that time I could taught the money and banking class.

Baum: That was just what made sense to me. The Keynesian world never made sense to me, and I knew a lot of them. I was lucky to know a lot of great monetarists.

Beckworth: So, mention some of the monetarists that you were exposed to, you've talked to. I know one's passed away, one's still alive, so tell us the big one who's influenced your life.

Baum: Bob Loren was a Friedman student at Chicago, and went to the Chicago Fed, and he did the early research on the yield curve, and for some reason, this is what makes most sense to me, and we always joke about it, but the spread between a Fed-pegged overnight rate and a market-set long-term rate just makes so much sense to me that there's this internal equilibrating mechanism.

Baum: And, he had done the early research as to how the spread-led money. A steep curve is an incentive for banks to expand their earning assets. We know that money and credit lead the business cycle and when the short rate is artificially pushed up above the long rate, well, watch what happens to money and credit, it's contractionary and it's the best leading indicator that there is. It's available 24/7, it's not proprietary, and yet, everyone always finds a reason to find why it's different this time. This time is different.

Beckworth: Well, we'll get to that in a little bit. So, tell us more about, again, your thinking because as listeners know, I've been called a market monetarist. It's kind of neat to get a fellow minded monetarist on the other side of the microphone, not that often these days. So, you worked with him, you also worked Robert Hetzel, which was a previous guest on the show, and he's still at the Richmond Fed. So, tell us about your experience with him.

Baum: I always feel like a ... I don't know what the right term is, but Hetzel is just so far above me in the way his brain works and the way he thinks, but he learned from the master. These are people who were at Chicago at the time of the ... Friedman and Stigler. I once reviewed a book about the Chicago School, and the problem was I knew so much many better stories than they did. I couldn't believe all these good stories about Chicago, but it sounds like Chicago in its heyday was just a really intellectually stimulating center of the universe-type to be to counter the Keynesian theory.

Beckworth: And, you got to meet a lot of the students that came out of that program, and that in turn influenced your thinking and how you viewed financial markets, monetary policy, and other thinking.

Baum: It was learning from them and what made sense to me. Now as to modern monetary theory, that wackadoodle thing, that I don't know why it has the name monetary. I don't know what's happened to it.

Beckworth: Well, very interesting, but you've been doing journalism for 30 years. You've seen a lot over that time. It would be great to spend several hours talking to you about some of the things you've seen, but today I want to get into what you just touched on, among other things, the Treasury yield curve because right now it's beginning to flatten. As you mentioned, historically, if it keeps flattening to the point where we say it's inverted where short-term interest rates are higher than long-term interest rates, that has been the best single metric indicator of a recession to come.

Baum: In fact, when the conference board revised the Index of Leading Economic Indicators in 1996, it added it for the first time, and it is the leadingest of the leading. It has the longest lead time.

Beckworth: And, I've seen some research done that has shown that it's hard to beat it. If you look at a consensus forecast, look at models, the yield curve spread, the difference between that 10-year treasury interest rate and the short-term one is a great indicator. Let's talk about this a little bit more, let's flesh this out. You gave your theory for why it works. Again, just to be clear, if this spread, if this difference between the long-term and the short-term one, if it flattens, which means short-term rates are going up relative to long-term, and it could be, just to be clear, long-term rates are going ...

Beckworth: So, short-term rates stays put, but the long-term rates are falling. So, regardless of what's driving it, as long as that flattening the curves, and if it eventually inverts, we get a recession. So, tell us again your theory for why that is the case.

The Yield Curve Recession Theory

Baum: I like to look at these two rates as the short rate is a proxy for supply and the long rate is a proxy for demand. In other words, the overnight rate tells us something about what the Fed is doing with the supply of credit. And the long rate, not necessarily the treasury rate, is a proxy for demand for credit economy-wide. I find it very interesting that all these financial conditions indexes and specifically New York Fed president Bill Dudley would look at spontaneously falling long rates as stimulative.

Baum: It boggles my mind that you can think ... let's go to Scott Sumner, he never reasoned from a price change. Sometimes long rates falling are great or stimulative, but when you have this short rate as a guide, I just think it just tells ... it's such a simple story that I think all these PhDs, even Ben Bernanke in his speech you pointed out to me in 2006, very well-articulated reasons why it doesn't mean what it used to mean if it inverts this time.

Baum: What's most interesting right now is the Fed has told us the December rate hike is a done deal except for pulling the trigger, and they've got a few penciled in for next year. Bottom market hasn't gotten the memo. We are right back at a 2.3-something percent where we were two years ago before the Fed pulled the trigger for the first time. And, I think that means that the Fed's trajectory is going to be quite limited in this cycle.

Beckworth: Yes, so the Fed's getting ahead of the recovery, getting ahead of what the market thinks can and will happen to interest rates, but I like the point you raise about the 10-year treasury yield. You can't look at it in isolation is your point.

Baum: Correct.

Beckworth: It going down could be a sign of easing, it could also be a sign of weakness. It's like nominal GDP growth, economic growth is often correlated with that 10-year treasury, so you have to be careful in how you interpret it for sure. So, you outline, I guess what I would call kind of a bank spread story, interest spread margin story where bank profitability ... so, bank profitability is really dependent ... one thing it's dependent upon is this yield curve spread, so the banks who borrow short-term at low interest rates and they lend at longer term.

Beckworth: And so, it long-term rates are much higher than the short-term rates, then it's profitable because you're telling the story. There's money creation. I hadn't heard that, that's very interesting, kind of a monetarist take on the treasury yield curve. I had not heard that story.

Baum: Loren wrote this piece and I will send it to you, back in '88 or '87 about what led ... was it the real funds rate, money, and he came down as that the spread leads everything. The spread drives-

Beckworth: So, this is fascinating. He's a monetarist, so he's-

Baum: An old-fashioned one.

Beckworth: He is, and so he's framing the treasury yield curve in terms of the monetarist theory.

Baum: He died in 2005, so we don't know what his thoughts would be today.

Beckworth: No, but that's fascinating. I had never considered that framework, and maybe some of our listeners have and they can email me and suggest other explanations, but I do want to go to the more standard explanation, which is the expectations theory of long-term interest rates, and it says long-term interest rate, let's take a 10-year treasury is basically equal to the average of a bunch of expected short-term rates over that period plus some term premium.

Beckworth: So, this relies on kind of an arbitrage argument that if I'm going to lend 10 years or lend short-term for 10 years, the rate should equal on average over that period adjusting for some compensation, which is the term premium. So in other words, if the 10-year rate's going down, it could be because the term premium, the added compensation for holding a long-term bond is changing or it could be because the market expects short-term rates to be falling.

Beckworth: So, this is getting a little in the weeds here for our show, but going back to this scenario where the Fed doesn't change the short-term rate, but the long-term rates go down, long-term rates could be going down because the market expects short-term rates in the future to go down. So, this gets into the expectations, so in one of the stories you could look at now because the yield curve is flattening is the Fed is raising interest rates and maybe in the future they're going to go back down and that's been priced into the 10-year because the Fed's getting ahead of itself, it's making the mistake, and that could be a possibility.

Baum: Right, but that's what I'm saying is the market is telling us that this tightening cycle is going to be severely limited.

Beckworth: So, both this monetarist story and this expectation story can be interpreted as the bond market saying, "No, no, Mr. Fed. You're getting ahead of yourself."

Baum: Correct.

Beckworth: So, that's kind of the standard story, but there's also that term premium part of the story, which as you mentioned earlier, the 2006 Bernanke speech and yes, I have referenced it myself before. I used to use it in my classroom lectures because he provides a great discussion of what causes yield curves to invert, either short-term rates are going to go down in the future, which would be a bad sign, the economy is going to get weak, or it's because of term premiums going down, which could be due to any number of things. Structural changes in the economy, accounting role changes.

Beckworth: So, today there's this similar discussion going on. Is the yield curve flattening because the Fed's making the mistake, or is the yield curve flattening because of some other external pressure for long-term treasuries? Do you have any thoughts? What do you think?

The Flattening of the Yield Curve

Baum: I've read and heard the term premium argument, but I think I'm going to defer to what an economist told me years ago, which is we live in a nominal world. The economics profession is focused on real, but when was the last time a friend, not a financial friend, told you the real rate on a 30-year mortgage he just got? So to me, I just think of the nominal yield curve. The components to me are less important about why that long rate is falling from the incentive, I'm a bank, if I can borrow 1% and the old days I could buy maybe a 10-year note at 5%, boy, that's a risk-free return of 4%. Sounds like a good deal.

Baum: Even if I'm choosing not to make riskier loans, there is an incentive to buy risk-free treasuries to increase the money supply. So, I plead a little ignorance on the term premium because I don't know that I've read all of these academic work, but I'm very simplistic in how I view the curve.

Beckworth: There's something to that. I imagine even many bankers don't necessarily think about those long-term treasury yield and decompose it and those components. We had a previous guest in here, Matthew Klein, and he's at the Financial Times and he's written several pieces that have criticized, that have looked at the problems with estimates of the term premium. So, you're right, you only observe the 10-year treasury interest rate and in order to break it down into the expected short-rate part of that in the term premium, you have to do this empirical exercise and try to decompose and that becomes an art. There's science and there's art.

Beckworth: So, it is tricky. There's no doubt about that, but let me frame this perspective a different way. So, many people are now observing that, look, there's insurance companies, pension companies that have to match long-term liabilities with assets, so that increases the demand for 10-year treasuries. There are passive mutual funds that are investing in 10-year treasuries. The treasury just announced that it's going to shorted the average maturity of the debt is an issue going forward.

Beckworth: So, there's a supply and demand story here some people are telling that the demand for long-term treasuries is elevated, the supply might be shrinking. That might be a reason why 10-year treasuries aren't going up with the Fed raising rates. That's the reason why the yield curve is flattening.

Baum: But see, that's a cause. I think there is also an effect. I like to write, and I've probably written it 10 times over the last 30 years. The what matters less than the why. How we got there, Ben Bernanke savings glut, that's fine, that explains why in the tightening cycle and the … that long-term rates didn't rise. But, once we get this inverted curve, it has an effect.

Beckworth: That's a good point.

Baum: So, I think the what is more important than the why.

Beckworth: So, no matter what got us here, this is a warning sign that we should be paying very careful attention to…

Baum: Exactly. It's still quite positive. Bob Loren always said 75 basis point spread was still a net positive in terms of the financial system.

Beckworth: I was reading one person's looking at the 10-year minus a two-year and it's the lowest it's been since 2008. You're like, "Oh."

Baum: But, that's a trader thing. Traders look at that spread. I look at it from the bank and the money creation process.

Beckworth: So, what you're saying is let's don't freak out yet, let's just keep an eye on the ... it's getting red, it's not red enough, it's not screaming red alert, but it's getting there, so it may be mindful.

Baum: But, it's deaf to what the Fed is telling us.

Beckworth: It is.

Baum: That where short-rate is going to be a year from now.

Beckworth: That's a big global market treasury, so the Fed is kind of a ... and that gets into another discussion, how consequential is the Fed in the Treasury market. But, the bottom line is, we need to be paying attention to it. You're a big believer in it. It has never failed you, right?

Baum: No.

Beckworth: I know if you go back far enough, there's a few episodes where it's missed.

Baum: But, I don't know what the Fed was doing with the overnight rate at the time. They weren't on a real Fed funds rate target. So yes, back in the 60s there were a couple of times-

Beckworth: But for the most part, it's done a really good job, and in fact, it's Bernanke's speech in 2006, who just becomes Fed chair, one of his first speeches he gives on the treasury yield curve because it was inverting then, and he basically ... it's a great speech if you want to get a good intervention to this mechanics of treasury yield curves, but at the end he says, look, I'm not a forecaster, but if I had to say something, don't worry about it. It's all the term premium, it's all this demand for long-term treasuries, and low and behold it was more than that.

Baum: And, it was a very long lead time. The curve inverted in mid '06 and the recession officially started in December '07. It's usually about a year, but this was long, and I remember having arguments with people when I started writing about this.

Beckworth: And, this happened also in '99, 2000, the yield curve inverted before that recession, and I had this discussion and actually last evening I was with some reporters in the Wall Street Journal while I was visiting with them on what does it mean right now, a similar discussion we're having now. One of the issues that I've wrestled with, I call the Beckworth Puzzle, but I just wrestle with the two, but something that really has vexed me is it seems like the last few recessions, the Treasury yield curve has begun to signal something's wrong, maybe the economy's going to weaken, or we're going to in a recession long before the stock market has.

Beckworth: And, you had a recent article on that titled *Bonds are from Venus, Stocks are from Mars* and that kind of speaks to this tension I have, and here is why I find it perplexing. So, the bond market is signaling potentially that we're going into a recession or the economy's going to weaken, and you can make these arguments why it's not, like Bernanke did in 2006, but given that it is and we're headed there, the stock market is screaming good times ahead.

Beckworth: Hey, things are looking great. The economy is upbeat, and I guess what's perplexing about that is it is not like people in the stock market are oblivious to what the bond market is saying. If I'm in the stock market, I'm a thoughtful person. I can look at my friends. I may even have one hand in the bond market, and you think arbitrage, this knowledge would lead these two markets to be more aligned. So, what is your take on this?

Baum: I wonder if it isn't because in the stock market it's the long rate that is used to discount future earnings.

Beckworth: That's a good point.

Baum: I'm not really sure, but there have been several instances where the stock market was the last to know, and we have been getting tremors in the junk bond market, which are joined at the hip to the stock market. It's a good question. I don't really have an answer, but again, they might be reasoning from a price change just looking at the long rate and here over here in bond world on Venus. We've got the two rates, which play together, but it's a good question, and we'd call it a conundrum. I think we might elevate it to the Beckworth Conundrum.

Beckworth: Well, it's not unique to me, but it's something that I'm sure someone's researched, and I may have overlooked a finding, but it does seem to be a bit of a puzzle, and again, it kind of goes against the efficient market hypothesis I guess, is what why I find it troubling. Maybe it has something to do with the growth of passive investing, I don't know, but this has been a phenomenon I guess for a long time.

Beckworth: Anyway, it's an interesting discussion. In your article, I think it's framed great, Bonds are from Venus, Stocks are from Mars. So, summarize that article for us. What are your highlights?

*Bonds are from Venus, Stocks are from Mars*

Baum: Well, the stock market is booming. We read all these reasons, which is expectations of corporate tax cuts. Earnings have been solid, deregulation, one thing that Trump has been able to do. So, now we have the Fed talking about maybe rolling back some of the Dodd-Frank regulations. So, that's all good for business.

Beckworth: It's supply side.

Baum: Yeah, and over here in bond land, we've got the yellow caution light flashing, and stuff like that. So, they do seem to be telegraphing different worlds as I said. Last week, I think there was some flutters in the junk bond market, the spreads had been quite low, the reach for yield. We live in a low worldwide rate environment, and you've written a lot about safe assets and stuff like that. So, 'tis a puzzlement, as Yul Brynner would have said in Anna and the King of Siam, The King and I.

Beckworth: It is, and like you said, if the yield curve is right, if the Fed's making the mistake view holds out and is born out in a recession, it could be a while because 2006 to 2008, there was money to be made between that time. If you could have timed it perfectly, you could have made money in the stock market despite what the bond market was saying for several more years. It's a fascinating discussion.

Baum: When we figure it out, we'll let your podcast audience know. You will be the first to know.

Beckworth: That's right, we'll revisit this issue.

Baum: After our Nobel.

Beckworth: We'll revisit the issue after the recession hits and we'll say, "Okay, it was the Fed getting ahead or it wasn't." Let's move to monetary policy. We've touched on this, but since you have this monetarist background I want to get your take on some of the recent developments, particularly relating to inflation, and you've written several pieces on this, and so one of the interesting things going on, one of the other puzzles going on. The puzzle, depending on who you ask, or mystery, or the conundrum, and that is the Fed's low inflation.

Beckworth: So, you had one article entitled *The Fed Flunks Econ 101.* You also had another article titled *Tinkerbell Economics*, and the Fed itself has admitted it does not know what is going on with inflation, which is pretty scary from my view. If you're the central bank and you don't have a good theory for inflation, what are you doing there in the first place.

Beckworth: So, I think people do have better theories. I think there's some good explanations people come up with, but what is your take on this low inflation puzzle?

The Fed’s Low Inflation Puzzle

Baum: Well, last I heard, inflation was still a monetary phenomenon. When we got into the 2008 crisis and Bernanke began talking about monetary policy was more about the asset side of the balance sheet, not the liability side. We, the Fed, buys risk-free assets bringing down those yields. You, investors, have to go out and take risks. I always objected to that. Gram and Grandpa don't really want to go out and buy junk bonds, or penny stocks.

Baum: I was a little bit happier with the old Friedman-esque, the Fed puts out more money than the public wants to hold. The public spends it. Aggregate demand increases at some point, the economy can't provide the good and services that people demand and prices rise. So, if that is still true, and I haven't read differently, in the old equation MV equals PY. Money times velocity equals nominal GDP. Velocity has been plunging, it's no longer stable, and the Fed has for five and a half years, with two monthly exceptions undershot its 2% inflation target on the PCE price index.

Baum: The way I look at it is the Fed should either shut up or put up. In the 1980s, if you had inflation stable at 1.5%, okay, the target's two, but 1.5% is close enough for government work. Either you should accept it or if you really want to raise inflation, you don't start raising interest rates and drawing down the balance sheet. So, this is a real puzzlement to me. They talk about it all the time. It's clearly important to them. The latest excuse seems to be that inflation expectations are too low, which is why the Fed can't get inflation, actual inflation, up to 2%.

Baum: Well, no one told the central bank in Zimbabwe and the Reichsbank during the 20s that you needed to align inflation expectations. People knew they had to take a wheelbarrow full of Reichsmarks to the grocery store. So, that's the Tinkerbell economics. A Fed economist said to me ... what was the quote? He said, "If the Fed thinks that people need to believe that its policy is working for it to work, than something's really wrong."

Baum: So, a central bank can inflate. Our central bank has chosen to bottle up the reserves it creates by paying interest on excess reserves, which in some way limits the monetary expansion. So, I really don't understand the quotes coming out of the Fed about we have no theory of why this is working. They rely on their Phillips curve, which doesn't seem to have worked since pre-1970s. So yes, if these are the experts telling us that, what are we supposed to think?

Beckworth: So, why do you think the Fed has been reluctant to be more aggressive? Why is it so favorable to keeping inflation low?

Baum: Well, they can pull Friedman out of a hat and say long and variable lags. Excuse me. They look at the unemployment rate. Yellen's a long time labor economist, 4.4%, boy, wages should really be soaring, and it's not happening, and they're puzzled, and their model is broken, but they're not willing to trash it in favor of something else.

Baum: So, I find it very confusing, their actions and their talk. They want higher inflation, they're scared to death that the next downturn will hit without any room to lower interest rates.

Beckworth: The cut rates.

Baum: I think there's a lot of talk about keeping the balance sheet large, but I do think they're more comfortable with a funds rate target as am I at looking and analyzing the Fed.

Beckworth: Let me run this by you. So, I think part of the issue is the Fed is worried about overshooting 2% and I think part of that worry stems from fears about repeating 1970. So, there was a paper that was done a few months ago that looked at the FOMC makeup and it looked at individuals who had lived through the 1970, looked at their voting record, and those who lived through the 1970, the interpretation is they were scarred by that experience. It's kind of a cognitive bias.

Baum: That's interesting. You have to send that to me. I love that.

Beckworth: So, it's kind of a cognitive bias that you have this one jarring experience, which is not representative of what will happen, but you take that and you overcompensate for that. And so, they're fearful of repeating the 1970s. In fact, Janet Yellen has said as much, and in press conferences they've asked, "Well, will you overshoot?" She said, "No, we're not purposefully overshoot. We don't want to lose all our hard earned inflation fighting credibility because of the 1970s. We don't want to go there again."

Beckworth: So, I think there is this implicit concern about we're going to the 1970s, but it seems like we're erring on the other side, and what the article implies is it's kind of a generational thing. Neel Kashkari, who didn't go through that, he's less worried about repeating the 1970s mistake, and maybe in a decade we'll have a new generation of younger FOMC folks who have never been through it, and we'll go back to the 1970s, but it seems to me part of the almost maybe unconscious thinking is they're afraid.

Beckworth: They want a recovery, they want 2% inflation, but they're too timid to act because of what they've seen in the past.

Baum: I like that theory. I'm going to have to write about that. I really like that because years ago I had written something about ... I was comparing the Bundesbank to the Fed, and I said for the German central bankers, the seminal event in their history, in their DNA was the hyperinflation of the 1920s. For the Fed, ever since Friedman and Schwartz published Monetary History, it's been widely accepted that the Fed screwed up in letting the money supply contract by a third in the early ... I think '29 to '33 or something, but now that's interesting. With the new generation, I may have to change my DNA theory about what they're taught in school. That's very interesting. I'm going to read that paper.

Beckworth: Your argument though is that no matter what's causing it, they have the ability to offset monetary velocity. So, your concern is look, the velocity of money has fallen, and no matter what caused it, and maybe there's things happening out there that are causing it to go down, but the Fed should be offsetting it, so that it hits its target.

Baum: If they want to hit the target.

Beckworth: If they want to.

Baum: I'm saying there are ways to do it, and what they're doing is counter. So, either talk about, be happy that you've achieved price stability, whether it's numerical or according to Alan Greenspan's old definition, which is inflation low enough, so that it's no longer a factor in business or household decision making, and I think we have got ... I don't think businesses ... they're used to this world that we're in. It seems to me they've achieved what they're looking for, but half a percentage point?

Beckworth: Well, it's interesting, the Atlanta Federal Reserve Bank did a survey of businesses and its district, and the businesses are now beginning to concur that the 2% is a ceiling, so it's not a symmetric target. So, even businesses are becoming cognizant. It's not just people like you and me who think about them. They're beginning to see 1.5% as more maybe closer to the target, so great. You're right, if that's your target, say so, but that of course creates other problems for them in terms that they want to have that cushion in the future.

Beckworth: But, the issues then they've talked about a symmetric 2%, they just haven't been able to produce or not willing to produce one.

Baum: And the other funny one is, they're going to raise their inflation target, so you can hit the 2%, but let's put it at four. Try hitting the two first.

Beckworth: That's what the cynics about monetary policy would say, and many have said it to me, so why do you think you could do nominal GDP target, why do you think you can raise inflation if you can't hit 2%? Your reply would be, well they can, they're just choosing not to. Is that right?

Baum: I think that would be my answer.

Beckworth: Well, let's look at the shocks that are causing money velocity to go down. So again, we'll operate under the premise that the Fed could offset these shocks, so if V's going down, they need to stimulate the economy and the fact that we make M go bigger by lowering rates. What do you see as things that are keeping money velocity low? Is it the Fed itself, or are there external things going on in the world that you think that are causing velocity to go down?

The Factors Affecting Money Velocity

Baum: Well, it started when? It started a couple of  ... but, didn't it start earlier than and it was no longer stable?

Beckworth: I think it was I guess it accelerated in the crisis.

Baum: Right.

Beckworth: Well, let me throw something out ... here's my theory. So, I think fiscal policy's actually a part of the low inflation story. But again, the Fed in theory could offset this if it's doing its job well. But, I think this goes back to the safe asset shortage story that I've talked about before you referenced earlier. That around the world there's this increased appetite for safe assets. Safe secure stores of value, US Treasury's been the biggest abundant source of that, but also Germany's public debt would be another example, the UK, and given there's this elevated demand for these safe assets, it effectively has reduced the fiscal cost for long-term debt issues for the US.

Beckworth: So, it's improved the long-term fiscal condition of the US government, which means that in the future there's going to be less debt monetization, less concern about that, which in turn affects velocity today. In other words, if the world's willing to stand at the treasury's door, and knock on it, and beg for more debt, then there's less concerns about that debt having to be monetized in the future. The markets more competent, and therefore there's less worries about inflation accelerating in the future in order to pay that off to monetization.

Beckworth: So, what that means is less debt monetization in the future, lower velocity today. So, better long-term fiscal health means less debt monetization and in turn means lower money velocity today. So, as long as the world wants our treasuries, we're going to have this drag on money velocity.

Baum: Again, I haven't thought that much about it, but that makes sense to me. I'm not sure I can add anything.

Beckworth: It's kind of the flip of Zimbabwe. Overnight, if we lost confidence in the fiscal health of the US Treasury, US government, what would immediately happen? You would see people unload treasuries quickly, the velocity of money would go up, and so this is just taking it to the other direction. And you have to ask, what would be driving that? And, it's this increased demand for safe assets, so that would be my take on why velocity has been going down and seems to be persistently low.

Beckworth: Some people have suggested government could issue more debt is one way if you wanted to get inflation up, but I think the more direct route would be for the Fed to respond.

Baum: More M for less V.

Beckworth: All right, so speaking of the fiscal health of the US government, something that's been a recurring theme for us, for the US government, for Congress, or Treasury has been the debt ceiling, and you wrote a piece in September. It's titled, It's *Time to Get Rid of the Debt Ceiling*, and right about the time this was an issue again. So, tell us what you wrote in there, and what's going on.

The Debt Ceiling and US Fiscal Health

Baum: Well, the debt ceiling really is not about funding the government, the debt ceiling is having the money in the bank to pay the bills. Congress passes its 12 appropriation bills, or should pass them for the new fiscal year, they don't often. They pass a continuing resolution, which keeps spending at the levels, and we know that the greater part of the government, Medicare, Medicaid, and social security is on automatic pilot, and then all of a sudden we get to the point, and the government can't borrow to pay what it has already committed to spend.

Baum: So, I think the goal should either be to better correlate the two, such as when Congress decides this year's budget will be X-trillion, well, how do we pay for that spending that we've authorized? That would seem to link the two. This way, I think in the public's minds it's very confusing. The debt ceiling gets confused with can we fund the department of education, and things like that. That's already been done.

Baum: So, right now you can see no matter what party is in power, they accuse the other one of playing political football with the debt ceiling. So, it's hard for me to understand what the function is and it would give a sense of fiscal responsibility if you tied what the government intends to spend with its ability to raise the money to pay for it.

Beckworth: So, it's been more of a distraction.

Baum: Yeah, good point.

Beckworth: It doesn't really get at the core issue is what you're saying. It's focused on your spending and obligations related to that. It's interesting, one of the consequences of the theatrics that go on with this is the Treasury General Account at the Federal Reserve. I happen to look at the Federal Reserve's balance sheet and the treasury has its own checking account at the Fed, and they increased that quite a bit.

Beckworth: It's gone up for a number of reasons, interest in the fiscal reserve has driven more of treasury funds into its checking account at the Fed, but it actually went up quite a bit, and then they had to bring it back down when they pass the debt ceiling extension, which I think goes to December if I'm right.

Baum: Yep.

Beckworth: They said in there, they said you can't game up the Treasury's General Account. You can't increase it a whole lot during this period, so that once the debt ceiling does kick in again, you can draw upon that. Treasury's checking account, the Fed had been growing dramatically. It actually had been expanding it, and then someone in Congress caught it or noticed it and part of this resolution, we'll extend it, but one of the fine points, some were down on the list was Treasury's General Account cannot be blown up because that would be one way to keep running things after the debt ceiling kicks back in.

Beckworth: So, you see all kinds of these side effects that are distracting, kind of beside the point. People at the treasury spending their time trying to play with the numbers.

Baum: And, the big issue is, in the early 2030, social security will not be able to keep the promises it made to retirees, so what we're doing now it's scary. They're fiddling while Rome is burning. We've got two lines, spending and receipts and the lines are growing further and further apart, and I don't know what they're going to do in two decades.

Beckworth: Maybe we should step back a bit, we're talking about the debt ceiling, just for our listeners who don't ... maybe we should kind of spell out actual debt numbers here. So, you often hear a 19, 20 trillion ... that's the gross public debt, but the actual one that we're concerned about is much larger than that, right?

Baum: You mean the publicly held debt? 14 and a half…

Beckworth: So, just so our listeners are clear, you shouldn't pay attention to the 19, 20 trillion figure because that includes debt that's held by the government itself. What you really care about obligations the government has to pay to people outside the government, so that's around 14 trillion, which has grown a lot, it is large. At the same time, we should recognize that the yield on that debt, the interest rate the government pays is really, really low.

Beckworth: So, the government is not viewed as a credit risk yet, but what you're saying is long-term, that's the real concern. So, we have 14 trillion, the bond market doesn't think it's a big risk yet. The long-term concern is all these obligations we've promised that we can't make. And, there's some folks who go and they get the net present value of future obligations that we ... and it's like over ... 75 to 200 trillion, some ridiculously large number, which I don't really take too seriously.

Baum: Neither do I because I-

Beckworth: Otherwise, the bond market would be exploding. Someone in fact recently asked me this, is it true that our long-term budget deficit is $200 trillion. I'm like, "Slow down."

Baum: What's the horizon, 75 year? I don't know-

Beckworth: It's a good way out and they add it up. The issue though is if this was really a big deal, the bond market would be exploding. Yields would be going up, we don't see that. So, either I think the bond market is saying either there's going to be some kind of reform on entitlements and/or taxes are going to go up.

Baum: Or, it's too far out in the future, and in the meantime the demand for safe assets is offsetting it.

Beckworth: So, those are the numbers, 14 trillion we got to worry about, and you're talking about doing something more reasonable. I want to throw a couple of ideas out there that have been suggested. One's called the Gephardt rule, and let me read what the Gephardt rule is. It's very similar to what you're suggesting, and this is actually something that was used by Gephardt, former leader of the House and it was used I think in the mid-90s, but whenever the House would pass its annual budget, the debt ceiling would be automatically raised by a corresponding amount. So, if you want to keep the debt ceiling kind of have it grow as the budget does.

Baum: Let the deficit hawks weigh in then, that's the time for them to weigh in.

Beckworth: That has to be their chance, and then there's another rule called the McConnell rule and under this approach ... this is still all the debt hawks to say their two cents worth and to say what they want to say, but what it would do, it would raise the debt ceiling a certain amount unless Congress would pass a joint resolution disapproving of that raise, and then the president would have the chance to veto it.

Baum: Oh, right. I remember.

Beckworth: So basically, all of the anti-debt folks would still have their chance to scream and carry on, and the president would get to raise the limit unless two-thirds of the Congress opposed him. So, it would be kind of a release valve, a pressure valve. So, you could still say, hey, why are we raising the debt? But then, if you need to get the financing going, the president could still pull the lever, so those seem more-

Baum: Link the two. It's a reasonable solution.

Beckworth: Right, so that's what you would kind of have in mind.

Baum: I think so, that would make sense to me. Ex post, we've committed to spend that, so what's the option, default?

Beckworth: One thing I have wondered, with all the problems the fiscal cliff, and the sequester, all those theatrics, and the noise, the debt ceiling has created, and I don't think ... I agree with you, I think it's inefficient. It's not the best way to get things done, but it does send a signal. It does send a signal that Washington D.C. is still at least somewhat interested in long-term fiscal solvency. It does send a signal to the bond markets that we are thinking about this issue.

Beckworth: So, I wonder if to some extent, even though it's inefficient, it's not the best way to run things, I wonder if it's still important to the fact it sends a signal that we're not a banana republic yet. So, the demand for safe assets remains elevated. People still want to buy US treasuries because they see we're still wrestling with these issues. So, even if it doesn't accomplish anything, even if we're wasting time, it's a signal that we're still serious.

Baum: Correct, but it would be a better signal if it were linked to the spending.

Beckworth: No, I agree with you. I want to see something more efficient done, but I just want to recognize that maybe all the theatrics are important in an indirect way, maybe to the bond market. They like to see that we're at least somewhat worried about long-term obligations. All right, so let's move on to recent changes at the Federal Reserve. Jerome Powell got the nod from the president, any thoughts on that?

The Recent Changes at the Fed

Baum: Like everything I've read, I think it's a consensus type of choice. A little more favorable towards Trump's anti-regulatory regime than Janet Yellen might have been, but status quo seems to me I don't expect anything major coming out of the change of leadership at the Fed right now.

Beckworth: Were you disappointed that he didn't reappoint Janet Yellen?

Baum: All things equal, again, if you're going to go with the consensus of status quo, Trump told us that he's a low interest rate guy. I didn't like it before the election, but now that he was elected, I don't see any reason why he wouldn't have chosen Janet Yellen other than Obama appointed her, and he had to do an in your face type of deal. I don't expect any huge changes.

Baum: Of course, there are a lot of open seats, and we'll have to see what happens there. I'm old-fashioned, I would like a PhD economist at the helm of the Fed. Yes, there are hundreds and hundreds of staffers with PhDs that could help the chair out at any time, but if you go to a doctor, you want someone with an M.D. So at the margin, I would have rather he renominated Yellen than a banker-type, a lawyer like Powell.

Beckworth: And so, we still have the vice chair position open. Although recently, Mohamed El-Erian formerly at PIMCO has been floated as a name. We don't know yet.

Baum: I read that.

Beckworth: He's more of a finance-type.

Baum: I wonder if Yellen will stay.

Beckworth: That would be interesting to see too. Will she stick around? I think it might be useful, but we'll see what happens, but there are a lot of seats that he could fill. He could definitely his… yes.

Baum: The Trump Fed.

Beckworth: Fed, exactly. What it would be like, what it would look like, so are you hopeful for monetary policy moving forward, or you think we're still stuck with interest rates and we need to go back to more money?

Baum: I'm of the school that we're in this 2% economy, 2% growth because of the constraints of the labor force and productivity. So, we either need the next new thing to come along to elevate productivity. Slow down actually began in 2004. John Fernald, well he was at the San Fran Fed, has done some excellent work on total factor productivity and things like that. In terms of the labor force, I'd like to see more skills-based immigration. It doesn't sound like that's going to happen under Trump.

Baum: So, whether these back-to-back quarters of 3% in the start of looking good for the fourth quarter, I don't know if it's sustainable, but until things change, my belief has been sort of more constrained, structurally constrained by how fast the economy can grow and the Fed is going to continue to take baby steps until the alarm goes off.

Beckworth: And, maybe that alarm might be the treasury yield curve soon.

Baum: It might, stay tuned.

Beckworth: Well on that note, we're going to end. Our guest today has been Caroline Baum. We thank you for being on the show.

Baum: Thank you for having me.

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