The Federal Reserve has a debt problem. It’s not their debt. It’s the record debt of the private and public sector that the Federal Reserve has helped fuel and sponsor during the pandemic crisis.
Directly and indirectly, the Fed is remaking the financial system to save the economy. But in the process, it might end up destroying it and itself.
Is anyone counting?
According to the Federal Reserve’s Financial Accounts of the United States, in the first quarter of 2020 new borrowings (debt and loans) by the nonfinancial sectors (which includes households, businesses, and government) totaled $1.9 trillion.
That represents the second-largest quarterly borrowing on record, topped only by the $2.1 trillion in Q1 2004 that occurred during the early stages of the housing boom.
But in Q2, a new debt record will be set. Indeed, record issuance of investment and non-investment grade corporate bonds, along with robust business borrowing at commercial banks and unprecedented debt issuance by the US Treasury could result in nonfinancial sector borrowing being as much 2X times that of Q1.
Record debt is occurring at the same time the economy is experiencing its sharpest two-quarter contraction in history. Nominal GDP in Q1 totaled $21.5 trillion, off about 1% from Q4 2019. But Q2 nominal GDP could be off as much as nearly 10% (not annualized) from Q1, according to consensus estimates. GDP is expressed at an annualized rate so the flow of new output and income in the first six months of 2020 is around $10 trillion.
Based on my count, the US could borrow as much as $6 for every $10 of new nominal output and income. Never before has there been so much new debt added over two-quarters and so little nominal output and income. The debt markets and the economy have never been more disconnected.
Before the pandemic, the Fed was concerned about excessive corporate debt and the growth in federal debt. In the Financial Stability Report issued in November 2019, the Fed noted that corporate debt levels were historically high relative to GDP and the ratio of debt to assets for all publically traded companies ---a broad indicator of leverage in the business world--was at its highest level in 20 years.
Moreover, just a few months ago in February 2020, Federal Reserve Board Chair Jerome H. Powell was telling Congress that putting the federal budget on a sustainable path would support the economy’s growth performance.
Yet, the Fed has abandoned all concerns about debt levels and is directly sponsoring and encouraging greater private and public debt. The Fed started the Main Street Lending Program working in partnership with banks to make loans to mid-sized companies. The program is estimated to cost $650 billion.
The Fed had previously established a new facility to invest in corporate bonds. The facility can purchase up to $750 billion. The impact of this program goes well beyond its scale as it increases the willingness of private lenders to lend and investors to buy corporate debt since the Fed is providing a large flow of liquidity to the market.
The Fed is also advocating Congress to do more to support the economy. Additional stimulus bills of $1 to $2 trillion are being discussed with final approval likely in July. How much new private and public debt will be created in the coming months is hard to predict, but no one is counting.
Market pricing of debt should reflect the wide disconnect between debt levels and economic risks and uncertainty. But it doesn’t. The Fed broke the market price signaling process with its backstop to credit markets as well as its purchases of debt securities and new lending facilities.
But something even more fundamental appears to be at work. The stigma and operational problems of high debt levels are no longer a concern to companies. Perhaps it’s based on the view that this new debt may be forgivable at some point, similar to the loans to small businesses that were made under the Payroll Protection Program, or that the current terms---no principal payments for two years-- will be eased again.
Policymakers do believe that they can easily remove these emergency credit programs once the economy recovers. Yet, the Fed’s record of reversing course is not good evident by the Fed’s attempt in 2018 to unwind its low-interest rates policy and scale back the size of its balance sheet. Removing credit programs will prove to even more difficult since these programs are a “lifeline” to some companies and directly impact economic output and jobs.
The Fed can no longer credibly argue that its policies don’t distort the financial markets. With its vastly expanded lending powers, to go along with its official rate-setting policy and asset purchase program, the Fed has become the financial system.
In trying to save the economy the Fed is increasing its vulnerabilities by fueling and sponsoring record debt borrowings. The excessive debt levels are not only a threat to the future performance of the economy but also represent a threat to the Fed's independence. That's because the Fed's debt problem is essentially the economy's debt problem.