By: Tim Hayes Financial Advisor - posted in: Economy, Markets, and Interest Rates - Last updated Feb 4, 2019

Why Tax Cuts, Combined With the Federal Reserve Reducing Its Balance Sheet, Is So Risky for Our Economy

by | Last updated Feb 4, 2019 | Economy, Markets, and Interest Rates

The 1% got $5 trillion of help from the Federal Reserve during QE. The bill for that support, which comes due just as the Fed reduces its balance sheet, just got sent to the middle-class through this new tax bill.

Burying the lead

One big flaw in the discussion about the congressional tax bill is the lack of understanding of the additional revenue from the sale of new government bonds that will be required to fund the government. Such bond sales would result not only from the loss of revenue from the tax cut but also the necessity to sell more bonds to bankroll the government as the Fed reduces its balance sheet.

More bonds for sale will push interest rates higher, which could result in the following:

  1. Investors who own bonds will see them drop in value.
  2. Real estate mortgages will become more expensive.
  3. Higher interest rates could eventually cause the stock market to fall and push the economy into a recession

Why more bond sales are needed

The current deficit is around $440 billion. This means the government spends $440 billion more than it receives in taxes and sells $440 billion of U.S. Treasury notes and bonds to make up the difference.

The Joint Committee on Taxation, a nonpartisan group of experts, estimates that the new tax bill will reduce revenue by approximately $1 trillion over the next ten years, or $100 billion per year.[i] So, in order to fund the government that is to pay for military spending, education, veteran’s benefits, energy and environment, housing, etc., $1 trillion of new bonds sales will be needed.

Adding to those sales, the Fed recently announced a reduction of its balance sheet. This means each month the Treasury’s account held at the Fed—i.e., the government’s checking account—is reduced by the value of the maturing treasuries not reinvested.[ii]

In 2018, the Fed plans on not reinvesting $240 billion of maturing bonds ($360 billion in 2019).[iii] Add that to the $100 billion loss of loss revenue from the tax cuts, and the government’s checking account drops by $340 billion. This, at current levels of government spending, requires an addition of $340 billion to the current deficit of $440 billion, for a total of $780 billion of bonds sales.

Moreover, with the Fed owning about $2.5 trillion in treasuries, the U.S. government—i.e., the taxpayer—is on the hook to the Fed in the form of higher taxes or more bond sales for whatever amount the Fed decides to reduce this number by.

What Congress should have done

Instead of lowering taxes for the 1% and corporations, the government should have raised their taxes to payback QE, as they were the primary beneficiaries of that program. Plus, that option presents less risk to the economy than paying for QE with revenue from additional sales of government bonds.

Tax cuts, plus the ending of QE, could get you the perfect storm:

  1. Requiring additional bond sales to fund the government
  2. Causing interest rates to spike
  3. Resulting in a reduction in the demand for consumer and business loans
  4. Driving the economy into a recession
  5. Crashing the stock market

The housing market is particularly vulnerable

A combination of rising mortgage rates, inability of some people to write off parts of these higher rates, and the Fed no longer purchasing mortgage-backed securities (MBS) to support the mortgage market, could cause housing prices to fall.

Is there any way to avoid these risks?

You could make the argument that, with the Trump administration in trouble with Mueller, people might begin to lose faith in the economy and the stock market, thus rush from riskier investments in U.S. Treasury bonds and avoid a rise in interest rates. However, you could still end up with a recession and a significant drop in the stock market.

Alternatively, maybe the Republicans can drastically reduce the size of the federal government, which would reduce the need for additional bond sales. Yet this, too, could cause the economy to falter unless lower government spending is offset with type spending—i.e., investment in manufacturing plants, equipment, wages, etc.—which increases GDP, not the stock buybacks and dividends in which that companies have been engaging.

These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.

Notes

[i]    Pramuk, Jacob, and John W. Schoen. “Senate tax bill will fall $1 trillion short of paying for itself after economic growth, congressional analysis says.” CNBC, November 30, 2017. https://www.cnbc.com/2017/11/30/senate-tax-bill-would-still-add-1-trillion-to-the-deficit-after-growth-congressional-analysis-says.html

[ii]  Federal Reserve Bank of New York. “Statement Regarding Reinvestment in Treasury Securities and Agency Mortgage Backed Securities.” September 20, 2017. https://www.newyorkfed.org/markets/opolicy/operating_policy_170920

[iii] Ihrig, Jane, Lawrence Mize, and Gretchen C. Weinbach. “How Does the Fed Adjust its Securities Holdings and Who is Affected?” Finance and Economics Discussion Series 2017-099. Washington, D.C.: Board of Governors of the Federal Reserve System, 2017. https://www.federalreserve.gov/econres/feds/files/2017099pap.pdf

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