The Fed Is Fighting the Treasury Again. Last Time Inflation Hit 21%.

Federal Reserve and the United States Treasury currently have opposing goals and they are working against each other. And it looks very similar to how it looked in the 1940s and early 50s when the Fed and the Treasury came up with a new accord to figure out how to work together with these opposing goals. For context, this is the long-term debt-to-GDP ratio chart. It shows how much debt the US government has relative to the size of the economy. You can see that because of all the World War II spending and borrowing, the debt-to-GDP ratio shot up to 121 percent. And then following the cutoff of spending when the war ended, paired with yield curve control and other financial repression tools, the United States government was able to de-leverage compared to the size of the economy, bringing their debt-to-GDP ratio down to about 30 percent by 1974. So I mentioned two of them already, but the four ways they were able to de-leverage and bring down that debt-to-GDP ratio was, number one, austerity. They cut a bunch of spending. That is not something that can or will happen today. Sure, they could just cut spending, but nobody has the political will to do that. The second thing was a productivity boom. And that happened because all of the men came home from war and started working for productivity rather than for destruction, not to mention all the resources that got freed up to be able to start being used for productive purposes again. So there was a big productivity boom following World War II. And we are seeing a little bit of that right now with AI, but it is yet to be determined how much of that productivity increase will translate to economic growth. Now, the third way that they were able to bring down the debt-to-GDP ratio was through financial repression, yield curve control, essentially inflating the debt away. And from 1942 through 1951, the United States had yield curve control. This is a long-term chart of the 10-year yield. And that period of time with yield curve control happened right here. Zooming in on that time frame, we can see that the 10-year yield was capped at basically two and a half percent and the Fed did push it lower occasionally. But up until 1951, when that yield curve control ended, the 10-year yield was capped at two and a half percent and short-term yields were much, much, much lower than that, essentially allowing the government to borrow at basically free interest rates, especially when you account for the inflation that was happening. However, by the end of this, there was significant tension between the Fed and the Treasury. And that tension persisted until they came up with the Treasury-Fed Accord in 1951. And this is when the US Treasury and the Federal Reserve reached an agreement on how to separate government debt management from monetary policy. Essentially, the Federal Reserve didn't want to be there just to be a tool to monetize government debt. They didn't want to be there just increasing its balance sheet, buying up government debt, monetizing the debt, in other words, QE, just to let the government borrow at rates well below inflation. And it was much, much lower than inflation because between 1946 and 1947, inflation was a whopping 17 and a half percent. And then from June of 1947 through 1948, it was nine and a half percent. Meanwhile, the US government was borrowing at three-eighths of a percent on short-term treasury bills. In a completely free market, that would be unheard of. You would not be able to borrow at essentially zero interest rate when you are causing inflation to be 10 to 20 percent. And the Federal Reserve felt that the continuation of this peg would lead to excessive inflation. And so they tried to raise short-term interest rates, but they were successfully opposed by the Treasury. And then by 1951, the inflation rate had reached 21 percent. Hey, real quick, if you are an active investor and your portfolio is not growing as fast as you'd like, then I would like to give you a free gift. This is something I've been working on for a long time. My team and I put together a portfolio stress test. We looked at the top six risks that people are exposed to in their portfolios many times without even knowing it, and most importantly, what you can do to fix it. So we built this really cool questionnaire quiz on my website where you can input all the information about your portfolio, your investing goals, and it's going to spit out for you a customized blueprint that shows you where you're currently at and what you need to do to get to the next level. So no matter what is holding your portfolio back and no matter what risks you're exposed to, maybe without even knowing, I want to help you find and fix your vulnerabilities, again, completely free. 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Now, I hope you're starting to see the parallels, but just in case you don't see the parallels to what's going on today, I will make it clear in a moment all the similarities. But this one is, this one is even more kind of eerie because in 1951, President Truman invited the entire FOMC to a meeting at the White House. And then after the meeting, he said that the FOMC had pledged to support President Truman to maintain the stability of government securities as long as the emergency lasts. However, the FOMC had made no such pledge. And so shortly after that meeting, the Fed informed the Treasury that it would no longer maintain the existing situation. Now, in an attempt to stop this thing from completely blowing up and making the borrowing situation for the United States government completely untenable, the Assistant Secretary of the United States Treasury met with a few people from the Federal Reserve and they negotiated a compromise under which the Fed would continue to support the price of five-year notes for a short time. But after that, the bond market would be on its own. And so on March 4th in 1951, the Treasury and the Fed issued a joint statement saying that they had reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose and to assure the successful financing of government's requirements, but at the same time to minimize monetization of the public debt. In other words, the Federal Reserve was done being a tool to just monetize the debt at rates well below the rate of inflation, which was fueling the inflation. And so they came up with an agreement, they would do a little bit, kind of wean the government off of it, and then the bond market would be on its own after that. Now, in case you've been living under a rock, we have new leadership at the Federal Reserve. His name is Kevin Warsh. He is the new Federal Reserve Chairman and he is not a fan of the way the Fed has been run over the past 10-20 years. He has made it very clear that he wants to end the era of quantitative easing. He just made a big statement at Jackson Hole and he said that outside of controlling short-term interest basically all other tools that the Federal Reserve uses should be used for crises only. He has talked at length about wanting to drain the entire Federal Reserve's balance sheet or close to the entire thing. He does not like the status quo that the Federal Reserve has been there monetizing the US government's debt, in other words, quantitative easing. He's saying it's distorting the economy, transferring wealth from poor to rich, from wage earners and savers to asset holders, and it's making the Fed's job harder. And in his opinion, the only job that the Fed has is keeping inflation under control. Now, it's yet to be determined whether he will be successful at any of this that he is talking about so far, but it is very clear that this is a very similar situation to the end of yield curve control back in 1951, especially considering that United States Treasury, led by Scott Besant, is really trying to do the exact opposite. You can see yields on the 10-year have been going up recently, the 20-year, and the 30-year. And this small little decline in yields that has happened at the very long end over the last week or so is a direct result of Scott Besant's intervention in the bond market. Scott Besant drew a line in the sand and said, I do not want long-term yields to get above this point and I'm to do whatever it takes to make sure that doesn't happen. And the thing that he is willing to do to make sure that doesn't happen is retire his own debt. In other words, pay off that long-term debt early. Buy it off the market so that pushes prices up and yields down. Now, the Treasury does not have the capability to print dollars, so the only way they can do this is by borrowing an equal amount at the short end where there is demand. It's very similar to paying off some of your mortgage early that's a 30-year fixed rate interest rate and using a credit card to do so where you owe that money back in a much shorter period of time and the interest rate on that is variable. But it's very clear that this current administration, especially the US Treasury, wants long-term interest rates lower. At the same time, the Federal Reserve is saying, we want to get out of the business of trying to control long-term interest rates. We want the market to control interest rates. We want less intervention and the Treasury wants more. And so I think over the next couple of months, it is very likely that the Federal Reserve and the Treasury will get together to come up with a new agreement and a new path forward on the way that things are handled between them. If the Federal Reserve does what Warsh is saying he wants the Fed to do, they will be draining their balance sheet, they'll be raising short-term interest rates if inflation stays elevated above 2% and they will be making the job of the US government to borrow money at cheap interest rates way harder. And to be honest, if that's what were to happen, that would be a good thing because if you have an out-of-control government spending and borrowing up to their eyeballs way more than they can afford, you need the market to be able to put a constraint around that entity and say, no, that's going to be more expensive for you. However, looking at it through the lens of the Treasury and the US government, they want the exact opposite. They want to be able to borrow at extremely cheap, they'd love to be able to borrow at free interest rates, 0%, free 99, but they don't have the legal construct in place in order to be able to force that to happen on their own. Now, in my opinion, a couple of things are likely to happen here. Number one, a redefinition of inflation is coming so that the Federal Reserve can declare victory in their war against inflation without actually having to do much in terms of monetary policy. Number two, I think there will be some meaningful move in inflation, especially considering recent announcements like the Pentagon being in talks with Venezuela in order to take an ownership stake in oil fields there and the fact that Venezuela is now considering leaving OPEC. Energy costs are one of, if not the leading factor outside of monetary policy and the money supply contributing to inflation. And so if the United States can lock up agreements in order to bring down the price of energy, that brings down the price of production and transportation of every single thing that people use and consume and need for production. That brings down prices. And so I think there will be a redefinition of inflation, but there will also be a somewhat meaningful actual reduction in inflation. And so that should lead to some softening of interest rates, but not enough. And if you've been watching my videos for any length of time, you know that I think that the most likely move is to deregulate the banks by removing the supplementary leverage ratio. That would allow them to buy virtually an unlimited number of U.S. treasuries just like they did during 2020 and 2021. Because without a big buyer, the United States government has nobody to sell that debt to, and the Fed does not want to be that buyer. Foreign governments are just not buying as much as they used to, and it doesn't look like that situation is going to improve anytime soon. And so if the United States wants to sell a large, substantial amount of debt at much higher prices than they can sell it at right now, they need a buyer who can come in and scoop it all up. Right now, that looks like the only buyer that could be would be banks. And guess who regulates banks? The Treasury in conjunction with the Federal Reserve. So we'll see and I'll keep you posted on what's happening. But right now, that disagreement is coming to a head just like it did in 1951. So we'll have to wait and see what happens from here. And maybe we get a new Fed-Treasury accord. One last note, if you're an active investor and your portfolio is not growing as fast as you'd like, my team and I put together a completely free gift for you. It's called the Portfolio Stress Test. All you have to do is answer some questions about your portfolio and your investing goals, and then it will email you a custom blueprint that will help you fix the vulnerabilities in your portfolio that you maybe didn't even know were there. It's also going to give you access to all of my courses, hundreds of hours of education, strategies, tactics on investing and trading that you need in order to fix your portfolio. Again, this is all completely free stuff. I used to charge a lot of money for your gift free. To access it, just go to heresy.financials.com. The link is in the description below. Fill out the questionnaire, plug in your information. I'll send you that custom blueprint. You can get started. As always, thank you so much for watching. Have a great day.