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Investing.com -- President Trump’s long-running quest to bring the Federal Reserve to bend the knee just got a shot in the arm. With Governor Adriana Kugler stepping down, the president has a golden opportunity to stack the central bank with a loyalist. But as the shockwaves settle, some experts are warning: stripping the Fed of its independence, albeit a far-fetched scenario, sets up an economy primed for risk and debt—and, at worst, a world where the dollar’s safe-haven crown could be lost forever.
“The removal of the Fed’s independence and setting monetary policy to maximize near-term economic growth would lead to very concerning escalation of longer-term debt imbalances. It would also increase instability of the U.S. economy and financial system, provided that the initial positive growth consequences were not aborted by a full-blown bond market riot," MRB Partners said in a recent note.
Dangerous Extension of the Debt Supercycle
The first order effect of a politicized Fed would likely be seen in the debt market as lower rates encourage policymakers to push the debt Richter scale higher to quench their thirst for faster economic growth.
But this likely “substantial extension" of the U.S. Debt Supercycle, a free lunch: “Such policies can create a sustained period of above-potential economic growth, but at the expense of increasing longer-term economic and financial market instability.”
Treasury Market Shifts Sharply to Short-End Debt
With an administration bent on maximizing short-term growth, Uncle Sam would pivot sharply to short-term T-Bills, ditching longer-dated Treasurys to cut interest costs. But that move would be fraught with risk: Servicing costs would be tied dangerously to short rates, making U.S. debt more volatile, as the long end of the yield curve becomes less liquid, and true cost “savings” may be exaggerated, MRB said.
“This is one of the reasons the President is calling for deep Fed rate cuts, as it would dramatically cut debt servicing costs, albeit the savings being quoted are exaggerated based on our calculations," it added.
Private Finance Hooks to Floating Rates
The private sector isn’t likely to come out unscathed. If short rates begin a race to the bottom corporations would likely ditch long bonds for cheaper, floating-rate loans. Mortgage lenders could resurrect floating-rate mortgages, “improving affordability” and possibly reviving the U.S. housing market, albeit temporarily. But as MRB cautions, boosting home demand in this way seeds “even higher house prices” and piles new risks onto the financial system.
“This shift would enable banks to put their ample deposits to work and could thaw the frozen housing market by improving affordability, at least until home prices surge anew. New homeowners may intend to refinance...but such a day may never arrive," MRB warned.
Fed’s Fragility Rises, But So Would Its Economic Influence
Ironically, the Fed’s day-to-day sway over the economy would increase. With households and businesses hitching their fortunes to ultra-low short-term borrowing costs, any tightening cycle would pack a far bigger punch, making the entire economy hypersensitive to central bank moves and ratcheting up the risks of unintended recession.
“Over time the economy would also become reliant on short-term interest rates remaining very low… The Fed would become more reluctant to lift policy rates, even if inflation becomes problematic,” MRB said.
Endgame: The Threat to the Dollar Itself
Should faith in the U.S. government’s willingness, or ability, to repay its debts ever falter, MRB warns of a dire scenario: markets may shun even T-Bills, forcing the Fed to print money and directly buy government debt. That’s no longer just monetary policy, but a fast track to losing the dollar’s world reserve currency status.
“In this extreme outcome, the Fed would become the buyer of last resort and ultimately monetize U.S. government debt. However, this would end the world reserve currency status of the U.S. dollar.”
The party might feel good in the short run, but “fueling debt imbalances may create a roaring party, but will ultimately... end in a painful hangover or potentially an overdose.” Even if this scenario remains improbable, for anyone with a multi-year horizon, the risks are too great to ignore.