Washington’s plan to stick us with high inflation
The government wants to reintroduce the 30-year Treasury bond. That opens the door to inflation and higher interest rates that will help it -- and hurt the rest of us.
By Jim Jubak
Mark Wednesday, May 4, 2005, on your calendar with a big red circle. That way, 10 years from now, when you want to know exactly when the slide toward high inflation and high interest rates gained irresistible momentum, you'll know the exact date.
The big interest rate and inflation news didn't come out of the May 3 meeting of the Federal Reserve. This week the Fed had to take a back seat to the usually irrelevant U.S. Treasury Department, headed by John Snow. On May 4, Assistant Treasury Secretary Timothy Bitsberger announced that it is weighing reintroducing the 30-year Treasury bond that was last issued in October 2001. Within minutes, the price of the pre-2001 30-year Treasury bonds still on the market had dropped by more than 4%.
Why the big reaction? The Clinton administration's decision to stop issuing the 30-year Treasury bond was a convincing commitment by the federal government to holding the line on inflation and interest rates.
Funding the government with short-term bills and notes put the U.S. Treasury on the same side as consumers who owed money on their houses, cars and credit cards. Any increase in inflation and interest rates would immediately cost the government money and add to the deficit.
The fear of bigger deficits, of course, clearly doesn't stop most politicians from spending tax dollars. But by "going short," Clinton administration Treasury Secretary Robert Rubin had made certain that if the government decided to use inflation to reduce the real burden of the public debt, it would pay an immediately visible cost right now.
Suspending the issuance of the 30-year bond and funding the government's deficit with shorter-maturity Treasurys was a commitment that the government would try to keep future inflation and interest rates relatively low.
A jump to the other side
Reintroducing the 30-year bond now breaks that commitment and puts the U.S. government on the other side of the inflation and interest-rate divide from the rest of us. (Or at least from those of us who don't owe trillions and don't print our own money.)
If the U.S. Treasury starts to reissue 30-year bonds -- and the soonest it could resume the twice-yearly auctions for the bonds would be February 2006 -- then the government can lock in currently low interest rates on the 30-year bond (just 4.7% or so, even after the bond market sell off on May 4) for 30 years. It wouldn't cost the government an extra penny in interest on a 30-year bond sold to investors in 2006 if inflation spiked to 5% or interest rates climbed to 8%.
Consumers who owed money on their credit cards or held adjustable-rate home mortgages, however, would pay higher interest rates immediately.
Here's how the chief economist at New York investment bank Bear Stearns put it in an interview with the Bloomberg News Service on April 27: "It does not make sense for the government to be putting the interest-rate risk onto the household sector. By the government having shorter maturity for its debt, it takes the interest-rate risk on itself."
Maybe not for much longer.
It's clear why the U.S. Treasury might want to study reintroducing the 30-year bond now. The country faces a flood of potential new debt from what appears to be a permanent deficit -- as well as the never-ending need to roll over existing debt that has matured. And, while the Treasury announcement explicitly denied any connection between the proposal to resume issuing 30-year bonds and proposals to reform Social Security by borrowing trillions to fund a transition to private accounts, you can bet the Treasury is fully aware of the potential impact of solutions like that on the debt markets.
Let's not forget the funding problem created by a weak dollar, either. The huge U.S. trade deficit requires selling massive amounts of Treasury paper to foreign investors. If that paper is in short maturities, each month the Treasury must sell not only new paper but sell replacements for maturing Treasury bills and notes. Stretching out maturities to 30 years will gradually reduce that refunding burden.
A dose of cynicism
And finally, let's be really cynical and admit that the easiest -- and perhaps the only politically attractive -- solution to our various current budget and deficit problems is to inflate our way out of them. If we could just get inflation running at a comfortable 7% a year, say, then each year the trillions that we owe would be worth 7% less in real dollars, and tax receipts and other revenue would climb 7%, even without any real economic growth, making repayment so much easier.
Of course, any foreign (and I hope domestic) investor with any sense is watching like a hawk for the first signs that Washington intends to work its way out of its current bind on the backs of bondholders. If I thought my debtor was even thinking about stiffing me, I'd certainly ask for higher interest payments (and more collateral). reintroducing the 30-year Treasury given the current fiscal mess in Washington is almost guaranteed to lead to higher interest rates at the 10- and 30-year long end of the Treasury market. I ask, do you think our government can be trusted to deal honorably with its creditors over the next 30 years?
To a degree, an increase in the yields at the longer end of the Treasury market may be part of the purpose here. In February, Fed Chairman Alan Greenspan identified the current low yields on the 10-year Treasury as a "conundrum." Despite rate increases at eight Federal Reserve meetings that have taken the short-term target rate up to 3% from 1% since June 2004, the yields at the long end of the bond market have refused to move. In fact, at the close on May 3, the day of the Fed's latest rate increase, the10-year Treasury note was, at 4.18%, showing a lower yield than at the beginning of these hikes that started in June 2004. Higher long-term interest rates would help take some of the steam out of the domestic lending markets, especially the housing market. Which would suit the Fed, which is trying to avoid creating another asset bubble (or to gently deflate the current one, if you prefer), just fine. And higher U.S. long-term rates might also damp capital spending, helping to avoid overheating, in economies such as China and other developing economies since interest rates in those markets track U.S. rates.
Walking a fine line
The Fed is currently trying to walk a fine line between interest rates that are high enough to curb potential inflation and interest rates that are high enough to cut economic growth and possibly push the economy into recession.
The U.S. Treasury's decision on resuming the issuance of 30-year bonds walks a similarly fine line. A little doubt about Washington's fiscal intentions and future inflation rates will help push up long-term interest rates enough to get the kind of cooling that the Fed wants. Too much, however, risks a crisis of confidence that could send U.S. interest rates much, much higher as bond investors demand higher yields to make up for increased uncertainty.
The Treasury isn't set to announce a decision on resuming issuance of 30-year bonds until the Aug. 3 Treasury refinancing. Until then I'd expect the uncertainties in the situation to exert gentle upward pressure on yields at the long end of Treasury bond maturities (and gentle downward pressure on bond prices at this end of the yield curve).
Even after the decision to issue new 30-year Treasurys is made, and I don't think even John Snow's Treasury Department floats trial balloons like this only to deflate them, I don't expect a big decisive move in bond yields and interest rates. The Fed is likely to stay on course, delivering quarter-percentage-point increases in short-term rates until the target rate is near 3.75% or 4%. That will reassure the bond market that the inflation hawks at the Fed remain on watch.
And in the short run -- the next six to 12 months -- stock prices will be driven by worries over economic growth, fluctuations in oil prices and expectations for corporate earnings. Investors who want to make money in the stock market this year still need to build a portfolio balanced between energy and growth stocks.
But make no mistake about it -- the slide toward fiscal irresponsibility just got another coat of grease. And right now, with inflation hedges such as gold so out of favor, it's a good time to buy with an eye for the long-term.
After all, if the U.S. Treasury is thinking long term, shouldn't investors too?