#CreatorPad Investing.com - President Trump's long quest to subdue the Federal Reserve has received a strong boost. With the resignation of conservative Adriana Kugler, the president has a golden opportunity to appoint a loyalist to the central bank. But with shocks stabilizing, some experts warn: stripping the Federal Reserve of its independence, while a far-fetched scenario, sets up an economy vulnerable to risks and debt - and in the worst case, a world where the dollar could lose its crown as a safe haven forever.
"The removal of Federal Reserve independence and the adjustment of monetary policy to maximize short-term economic growth will lead to a very concerning escalation of long-term debt imbalances. It will also increase instability in the U.S. economy and financial system, provided that 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 effects of a politicized Federal Reserve are likely to show in the debt market, as low interest rates encourage policymakers to push the Richter scale of debt higher to quench their thirst for faster economic growth.
But this potential "great extension" of the super debt cycle in the U.S. is not a free lunch: "These policies can create a sustained period of economic growth above potential, but at the cost of increased economic instability and monetary market volatility in the long run."
The treasury market sharply shifts towards 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. However, 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 overstated, according to MRB.
"This is one of the reasons the president is calling for a significant reduction in federal interest rates, as it would greatly reduce debt service costs, even though the aforementioned savings are overstated based on our calculations," she added.
The private sector shifts to variable interest rates
The private sector is unlikely to emerge unscathed. If short-term rates 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 adjustable-rate mortgages, "to improve affordability" and perhaps revive the U.S. housing market, albeit temporarily. But as MRB warns, boosting demand for housing in this way sows the seeds of "even higher home prices" and adds new risks to the financial system.
"This shift could enable banks to invest their abundant 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 cautioned.
Rising fragility and the impact of the Federal Reserve
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 movements and increasing the risks of an unintended recession.
"Over time, the economy will also become dependent on keeping short-term interest rates extremely low... The Federal Reserve will become more hesitant to raise policy rates, even if inflation becomes problematic," MRB said.
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 terrifying scenario: markets may even avoid treasury bills, forcing the Federal Reserve to print money and buy government debt directly. This is no longer just monetary policy, but a fast track to losing the dollar's status as a global reserve currency.
"In this extreme outcome, the Federal Reserve will become the buyer of last resort 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 raucous 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 be ignored by anyone with a multi-year horizon.
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