This is one of those posts that is operational in nature, but will sound political to some people. Before you send me a mean email please try not to politicize the issue.¹ I hope this is helpful.
Here’s a question I got from Twitter:
“Cullen, why not let government bond markets be free and not manipulated?”
I see this one a lot and it’s based on a misunderstanding of “free markets” and how they relate to the government. So let’s dive in.
First, currencies are essentially imposed on us. So are governments. You don’t get to choose the currency regime you’re born into or the government you have. Yes, you can alter it and you could even leave it, but most of us get what we get.
Second, governments set the rules of the game and can’t be forced by market forces to do things they don’t want to do. What I mean by this is that “bond vigilantes” don’t control government bond markets. I’ll explain this in more detail below.
The Fed Funds Rate. The interest rate most people refer to when they say interest rates are “manipulated” is the Fed Funds Market. This is the interest rate controlled by the Fed (see here for more detail on the specifics of how rates are set). Importantly, the entire Federal Reserve System is a regulatory structure imposed on banks. Banks are required to have Fed accounts and only the Fed can supply the reserves that it requires banks to hold. And that market is a closed market only for banks. The kicker here is, if the Fed doesn’t set an interest rate on the reserves it issues in the Fed Funds Market then that rate will naturally fall to 0% because banks will try to lend them to one another and they can’t in the aggregate, get rid of them. So the Fed ALWAYS has to drive interest rates off of 0%. In other words, when you see a positive interest rate from the Fed they’ve actually manipulated that rate UP, not down as people commonly think. So, the bottom line is that the Fed Funds Market isn’t really a free market at all. It’s an imposed market that is set and controlled, either directly, or indirectly, by the Fed.
Treasury Bonds, Notes and Bills. In the current monetary regime, the government chooses to fund its spending by issuing bonds. Of course, the government could fund its spending in many different ways. For instance, it could choose to simply print new cash to be issued directly or it could credit the bank accounts of spending recipients. There would be no need to pay an interest rate in these cases. We also know from experience with Japan and the USA more recently, that the government can fund its spending by issuing 0% interest bearing notes of various maturity. In other words, as the issuer of the dominant risk free asset in the economy, the government need not pay you interest to create demand for its liabilities. This is especially true of environments with low inflation.²
The kicker here is that the government cannot be forced to pay higher interest rates if it does not want to. There are no bond vigilantes that control the bond market. There is not even a “free market” that dictates the terms of payment on government bonds. Yes, in the current regime the government chooses to issue long-term bonds and lets their prices float, but these prices largely reflect the long-term path of short-term rates which mostly reflect the expected long-term path of inflation. If the US government wanted to simply issue deposits or cash and completely halt the issuance of interest paying bonds then there is no nominal market force that could make them alter this policy choice.
As I’ve explained before, the government funds its spending at the cost of inflation. So, there is good sense in trying to peg the government’s liabilities to the rate of inflation since the real rate roughly reflects the market price of issuing new debt. Specifically, if inflation is high or rising then the government cannot be forced off its interest rate peg. Inflation could be 100% and the Fed could choose to keep rates at 0% if it wanted to. On the other hand, it’s clear that the government can increase the demand for its money by paying interest so there is strong empirical evidence supporting the policy change to raise rates when inflation is high. The key point being that the market doesn’t dictate the nominal terms of government interest rates, but can re-price and influence future interest rates via real rates (ie, inflation).
Conclusion. The key conclusion from all of this is that there’s very little about the government bond market and the Fed Funds Market that reflects some sort of “free market”. Yes, we are free to dictate the real terms of government money by altering its cost in inflationary terms, but we are not free to dictate the nominal cost of the government’s liabilities because the entire government is essentially a regulatory structure imposed on us. So, the next time you hear someone complain about interest rate “manipulation” feel free to send them this article so they can send me a mean email about the financial system.
¹ – If you’d like to send me a mean email please feel free to reach me at email@example.com
² – My personal view is that the government should pretty much always pay positive interest on its liabilities as this acts as a safe income buffer for the many savers who rely on this form of safe income to fund retirement and short-term spending needs.
NB – I did not discuss market rates such as corporate bonds or household loans because those rates largely reflect the risk free benchmark rate set by the government combined with some element of corporate and household risk (such as credit risk).