#CreatorPad Investing.com - President Trump's long quest to subdue the Federal Reserve received a strong boost. With the resignation of conservative Adriana Kugler, the president has a golden opportunity to appoint an ally to the central bank. But as shocks stabilize, some experts warn: stripping the Federal Reserve of its independence, though an unlikely scenario, sets the stage for a risk-prone economy and debt - and at worst, a world where the dollar may forever lose its crown as a safe haven.
"Removing the independence of the Federal Reserve and adjusting monetary policy to maximize short-term economic growth will lead to a very concerning escalation in long-term debt imbalances. It will also increase instability in the U.S. economy and financial system, provided the initial positive growth outcomes are not aborted by a complete disruption in the bond market," MRB Partners noted in a recent memo.
A dangerous extension of the super debt cycle
The first effect of the politicized Federal Reserve is likely to show in the debt market as low interest rates encourage policymakers to push the Richter scale of debt to higher levels to quench their thirst for faster economic growth.
But this potential "great extension" of the U.S. super debt cycle is not a free lunch: "These policies could create a sustainable period of economic growth above potential, but at the cost of increasing economic instability and the money market in the long run."
The Treasury market is sharply shifting toward short-term debt
With an administration determined to maximize short-term growth, the U.S. government will sharply shift to short-term Treasury bills, abandoning long-term Treasury bonds to reduce interest costs. But this move will be fraught with risks: debt service costs will be dangerously tied to short-term rates, making U.S. debt more volatile, as the long end of the yield curve becomes less liquid, and the "savings" may be exaggerated, according to MRB.
"This is one of the reasons the president is calling for a significant reduction in federal interest rates, as it would significantly lower debt service costs, although the mentioned savings are exaggerated based on our calculations," she added.
The private sector shifts to variable interest rates
It is unlikely that the private sector will emerge unscathed. If short-term prices begin a race to the bottom, companies are likely to abandon long-term bonds in favor of cheaper variable-rate loans. Mortgage lenders may revive variable-rate mortgages to "improve affordability" and perhaps revive the U.S. housing market, if only temporarily. But as MRB warns, boosting demand for housing in this way sows "higher home prices" and adds new risks to the financial system.
"This shift could enable banks to invest their ample deposits and could thaw the frozen housing market by improving affordability, at least until home prices rise again. New homeowners may intend to refinance... but that day may never come," MRB warned.
The fragility and impact of the Federal Reserve are rising
Ironically, the Federal Reserve's daily impact on the economy will increase. With households and businesses tying their fates to extremely low short-term borrowing costs, any tightening cycle will have a much larger impact, making the entire economy highly sensitive to central bank moves and increasing the risk of an unintended recession.
"Over time, the economy will also become reliant on keeping short-term interest rates extremely low... The Federal Reserve will become more hesitant to raise policy rates, even if inflation becomes problematic," said MRB.
The end: the threat to the dollar itself
If confidence in the U.S. government's willingness or ability to repay its debts is shaken, MRB warns of a horrifying scenario: markets may even shun Treasury bills, forcing the Federal Reserve to print money and buy government debt directly. This is no longer just monetary policy, but a highway to losing the dollar's status as a global reserve currency.
"In this extreme outcome, the Federal Reserve will become the ultimate buyer and will eventually convert U.S. government debt into cash. However, this will end the status of the U.S. dollar as a global reserve currency."
The party may look good in the short term, but "feeding debt imbalances may create a wild party, but it will eventually end... with a painful headache or perhaps an overdose." Even if this scenario remains unlikely, the risks are too great to ignore for anyone with a multi-year horizon.
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