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Comment by fuoqi | Hacker News Reader

Yes, many analysts have expected this to happen this year, but they underestimated stimulating effect of the COVID stimulus checks and the huge deficit spending by the government (e.g. Inflation Reduction Act, lol).

To be fair, the banking system has started breaking, but, instead of lowering the rate, the Fed has temporarily masked it by the BTFP. When the program will end, banks will end up with huge holes in their balance sheets (discounted paper + accumulated interest on BTFP funds). So we either end up with a huge banking crisis, or the Fed will prolong the program, thus effectively making it a form of QE.

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> many analysts have expected this to happen this year

They expected the economy to cool thereby causing rates to fall. Because what we're going through--rising rates, falling inflation and persistent growth--is literally the first time an economy of note has managed the opposite of stagflation.

The Fed being constrained by the federal deficit (or even interest expenditure) is a different beast. Nobody serious thinks the Fed would lower rates to finance the government thereby causing inflation. If the Fed is lowering rates, the economy is cooling. That's deflationary. If the economy is doing well enough that lowering rates would cause inflation, there is no need to lower rates.

Stagflation is real. But it's never happened in the way this theory describes (deficits --> lower rates --> inflation amidst recession). And there are simple, well-tested reasons to find that causation ridiculous.

> banks will end up with huge holes in their balance sheets

It's a trivial hole to fill: let banks borrow at the discount window against the face instead of market value of their Treasuries. (At a penalty rate, I would add.)

The persistent problems in banking come from credit risk. That's happening in commercial real estate. But not rates.

Yes, the Fed is independent and it should not care about fiscal deficits. On the paper. But the recent history shows that in practice it plays a bit differently... Also, there is a very enticing (for the government) example of Japan where BoJ effectively owns almost all of the Japanese government debt. Do not forget, that if things will get bad enough the Congress can always re-write the Federal Reverse Act.

>If the economy is doing well enough that lowering rates would cause inflation, there is no need to lower rates.

I am not naive enough to believe into the soft and no-landing scenarios. The gradual yield curve uninversion points to incoming recession. Huge fiscal deficits contribute to it, since without QE they cause crowding out of private debt markets.

>Just let banks borrow at the discount window against the face instead of market value of their Treasuries.

And, as I've said, it becomes another form of QE. If you set the penalty rate on the level of the current Fed rate, eventually banks will fail, since they can give enough loans at such rates and deposits actively flee into treasures and MMFs. And using lower rates will be rightfully seen as yet another bailout of banks.

> On the paper. But the recent history shows that in practice it plays a bit differently

What history? When did the Fed ever lower rates because of the deficit?

> Japan where BoJ effectively owns almost all of the Japanese government debt.

Help me understand why a large holder of debt would want it to pay less? (Also, Japan is a bad model for America.)

> not naive enough to believe into the soft and no-landing scenarios

That's fine. That's reasonable. What's not is thinking we'll have deficits cause lower rates and then inflation. If we have a hard landing, which is the historically-suggested outcome, we get lower rates and a recession. Not inflation.

> it becomes another form of QE.

No, because new money isn't being created. Existing money is not being removed. That's different.

> If you set the penalty rate on the level of the current Fed rate, eventually banks will fail

How?

> If you set the penalty rate on the level of the current Fed rate

It already is. This is how it works.

> since they can give enough loans at such rates and deposits actively flee into treasures and MMFs

How does the discount rate cause deposits to flee?

Also, what?! The discount rate is 5.5% [1]. Banks can borrow against the market value of their Treasuries at that. So for a dollar of face value, they can borrow ~60¢ at 5.5%. If we penalty that for face-value borrowing, they can borrow 100¢ at e.g. 8.5%. Help me understand how this additional liquidity causes whatever you're predicting?

[1] https://www.frbdiscountwindow.org

>What history?

The one where several trillions of deficit spending were fully financed by the Fed.

>Help me understand why a large holder of debt would want it to pay less?

Because the Fed is not a commercial organization and it's heavily influenced by politics. I will not be surprised, if in the following years financing of fiscal deficits by the Fed will be painted as a way "to save the economy" and to "fight unemployment".

>If we have a hard landing, which is the historically-suggested outcome, we get lower rates and a recession. Not inflation.

Yes, in the short term we will see deflation. But I predict that the hard lending will be painful enough for the Fed and the government to start stimulation of the economy fueled by bailouts and massive deficit spending. And this in turn will cause resurgence of inflation down the road.

>No, because new money isn't being created. Existing money is not being removed. That's different.

So taking a paper which costs $600 on the mark-to-market basis and giving in exchange $1000 is not a form of QE? Yes, those $1000 is technically a loan, but if you delay its repayment indefinitely, it becomes equivalent to creation of base money.

>How does the discount rate cause deposits to flee?

It's not the discount rate per se, but the Fed rate. If you can get 5.5% in a MMF (i.e. in RRP and short-term bills), why the hell would you keep your money in a bank's deposit for 1-2% together with risks associated with potential bank failure?

To attract deposits banks would have to provide competitive deposit rates, after that they would have to find someone trustworthy enough to give a loan at 10-15% rate. So the banks get squeezed from 3 sides:

- Either raise deposit rates or get money fleeing into MMFs.

- Not enough business is able to work with 10-15% loans in the face of worsening economic situation (especially after the recent near 0% environment).

- You still have to pay 4-5% on BTFP funds, which you had to take to offset fleeing deposits.

> one where several trillions of deficit spending were fully financed by the Fed

This isn't the Fed reacting to the deficit. Also, the Fed literally cannot directly fund the Treasury [1].

> I will not be surprised, if in the following years financing of fiscal deficits by the Fed

So ahistoric supposition.

> I predict that the hard lending will be painful enough for the Fed and the government to start stimulation of the economy fueled by bailouts and massive deficit spending. And this in turn will cause resurgence of inflation down the road.

See above.

> taking a paper which costs $600 on the mark-to-market basis and giving in exchange $1000 is not a form of QE

Do you consider any money creation QE? (This is incorrect.)

QE means starting with an amount of money to be created and then purchasing assets, including but not limited to government bonds, to create it. Central banks have always lent at the discount window. That's just money creation.

So yes, discount-window lending--whether at market or face value--is money creation. That's the point. It's used when a bank is in trouble, i.e. people want their deposits. So when a bank taps the discount window, it's turning a Treasury into a deposit at the Fed, but it's also typically destroying deposits on its own book. No net new money. Usually in a case of crashing money velocity. And certainly not QE.

> If you can get 5.5% in a MMF (i.e. in RRP and short-term bills), why the hell would you keep your money in a bank's deposit for 1-2%

Because I use my bank account to transact, not store value.

Also, interest rates are rising alongside bank deposits [2]? They've risen before? What you're describing has literally never happened.

> banks get squeezed from 3 sides

Bank margins go up when interest rates rise. Again, you're treating this like a novel situation. It's happened a lot of times in a lot of countries. What you're describing literally never happens.

This isn't even about making unprecedented predictions that have no theoretical basis. It's about misunderstanding the present state of the world. There are resources you can find at the Fed's website, if you're interested, as well as at the Bank of England.

[1] https://www.federalreserve.gov/faqs/money_12851.htm

[2] https://fred.stlouisfed.org/series/DPSACBW027SBOG

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