Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Ignores the Record $40 Trillion Debt
Transcript
- Lucas: So the U.S. government just crossed forty trillion dollars in total debt. That's more than double what it was a decade ago. And the Fed, under Chair Warsh, is basically acting like it doesn't matter. Luna: Right, and it's not just the Fed. Treasury Secretary Bessent is out there saying the deficit has probably peaked. But the numbers don't really back that up, do they? Lucas: They don't. The debt is still growing by roughly two trillion a year, and interest payments are now eating up a bigger share of the budget than defense. But here's the thing — the Fed has a very specific reason for ignoring it, and it's not because they're careless. Luna: Okay, I'm biting. Why does the Fed get to just look past forty trillion? Lucas: Because it's not their job. The Fed's mandate is maximum employment and stable prices. Debt sustainability is a fiscal issue, not a monetary one. Every time a Fed official gets asked about the deficit, they say the same thing: that's Congress's responsibility. Luna: But it still has to affect what they do with rates, right? I mean, the Treasury yields say the market is nervous. Lucas: Exactly. The ten-year Treasury is at four point seven four percent right now, and the thirty-year is at five point two eight. Those levels reflect investors demanding more compensation for the risk of holding long-term U.S. debt. But the Fed's tools operate on the short end. They set the federal funds rate, which is at three point six three percent, and they've held it there for months. Luna: So the market pushes long-term yields up, but the Fed is like, not my problem. Lucas: Pretty much. And there's a subtle thing here. The Fed's own portfolio is the elephant in the room. They're still holding a huge amount of Treasuries from the quantitative easing years. As those roll off, the Treasury has to find other buyers. If the Fed isn't buying, someone else has to absorb forty trillion and rising. Luna: And that's why we see these higher term premiums, right? The market is pricing in the supply. Lucas: Right. The term premium is back. It's a measure of how much extra yield investors get for taking on duration risk. That number has been positive lately, which is a big change from the last decade when it was often negative. And a big part of that is the supply story. Luna: So if the Fed is ignoring the debt, what are they actually watching? Lucas: The classic dual mandate stuff. Inflation, which is cooling but sticky. Headline CPI is at three hundred thirty-two point eight, a year-over-year rate that's hovering around three percent. Core is even stickier. And the labor market is softening but not collapsing — unemployment fell to four point one percent, but payrolls are barely growing. Luna: So they're stuck. Inflation isn't low enough to cut, but the economy is slowing. Lucas: Exactly. Real GDP growth came in at one point five percent annualized last quarter, down from two point one. It's not a recession, but it's not exactly roaring. And with core PCE still above two percent, the Fed can't justify a cut just yet. Luna: And the president keeps tweeting that they should cut rates. Lucas: Yeah, Trump has been public about wanting lower rates. But Warsh and the FOMC seem to be holding the line. They don't want to repeat the mistakes of the seventies, cutting too early and letting inflation re-accelerate. Luna: But at some point, the debt has to matter for them, doesn't it? I mean, if the Treasury market seizes up, they'd have to step in. Lucas: That's the irony. They'll act if there's a crisis, but they won't act to prevent one. Remember the repo market episode in 2019? The Fed had to step in when funding costs spiked. And during the pandemic, they did whatever was needed. So their approach is effectively, we'll ignore the debt until it becomes a problem, and then we'll use our balance sheet to fix it. Luna: So it's not that they don't care, it's that they're choosing not to care until they have to. Lucas: Right. And the risk is that the longer they wait, the less effective their tools are. If the debt burden gets so large that the market starts to question the U.S.'s ability to repay, then the Fed can't just step in and buy everything without fueling inflation. That's the real nightmare scenario. Luna: And that's why Bessent is trying to do things like the Treasury buyback program. To show the market they're on top of it. Lucas: Yeah, he mentioned a buyback operation that could be more than four billion dollars. It's a signal, but it's small change compared to the overall issuance. The Treasury still has to sell trillions in new debt every year. Luna: So what does this mean for the average person? Like, does the forty trillion show up in mortgage rates or something? Lucas: It does. The ten-year Treasury is the benchmark for mortgage rates, so when it's at four point seven four percent, that's pushing thirty-year mortgage rates higher. And that feeds into housing affordability, which is already tight. So even if the Fed holds short-term rates steady, the long end is doing the tightening for them. Luna: It's like the bond market is the real Fed. Lucas: That's a good way to put it. And that's actually the thing the Fed can't ignore. If the bond market starts to price in fiscal dominance — where the central bank is expected to monetize the debt — then inflation expectations jump. And we're already seeing ten-year breakevens at two point three four percent, which is above the Fed's target. Luna: So the Fed is kind of caught between the bond market and the politicians. Lucas: Exactly. And on that note, I want to be honest about something. This show is made possible by a small group of listeners who chip in monthly through buy me a coffee dot com slash fexingo. That's what keeps us ad-free and independent. If you've been getting value from these conversations, that's the best way to make sure we can keep doing them. Luna: Yeah, it really does make a difference. And it's how we keep the lights on without trying to sell you anything. Lucas: So speaking of things the Fed can't ignore — the labor market. Even though unemployment is at four point one percent, job openings are still trending down. JOLTS came in at seven point three five nine million, down from seven point five three seven the month before. And initial jobless claims are at two hundred and six thousand, which is low, but the trend is creeping up. Luna: So the Fed has to balance that too. If the labor market really starts to crack, they might have to cut even with inflation above target. Lucas: Right. And that's the tightrope. The market is pricing in a decent chance of a cut by December, but the Fed is not committing to anything. They're data dependent, and the data is mixed. Luna: So what's the one thing you'd tell a friend about all this? Lucas: I'd say the forty trillion dollar debt is a slow-moving problem, and the Fed is deliberately not reacting to it. But the bond market is the real check on fiscal policy, and its signal is getting louder. If you want to understand where rates are going, watch the ten-year yield, not the Fed. Luna: And maybe watch the term premium too. Lucas: Exactly. The term premium is making a comeback, and that's the market's way of saying the debt matters. It's not a crisis yet, but it's a warning. And the Fed is choosing to hear it or not.