E.J. Antoni: The Fed Is Trapped and Will Be Forced to Inflate Away the Debt

Key Concepts

• Federal Reserve Policy: Interest rate cuts, quantitative tightening (QT), quantitative easing (QE), balance sheet reduction, ample reserve regime, interest on reserves, yield curve control.
• US-China Trade War: Tariffs, trade truce, rare earth minerals, soybeans, fentanyl.
• Economic Indicators: Inflation, federal deficit, Treasury yields, gold prices, auto loan delinquency, credit card delinquency, commercial real estate, consumer spending, bank reserves, GDP.
• Financial Markets: Stock futures, dollar strength, Treasury yield, gold, repo market, secured overnight financing rate (SOFR), regional banks, SVB, Wall Street, Main Street.
• Data and Policy: Government data blackout, Bureau of Labor Statistics (BLS), data accuracy, alternative data sources, policy vacuum, transparency, credibility.
• Monetary Theory: Monetary malfeasance, monetary inflation, wealth effect, risk-free rate of return, moral hazard, permanent monetization.
• Alternative Assets: Gold, Bitcoin, real estate, cows, bulls.
• Leadership and Reform: Federal Reserve leadership, data reform, balance sheet discipline, restoring Fed's independence, Kevin Warsh.

Market Indecision Amidst Crosscurrents

The market is currently experiencing indecision due to a confluence of powerful crosscurrents. Stock futures are wavering, the dollar is showing strength, and the 10-year Treasury yield is holding steady at approximately 4.1%. Gold is struggling to reclaim the psychologically significant $4,000 level after recent declines. This market sentiment is a direct consequence of major events in the preceding 24 hours.

Federal Reserve's Hawkish Pause

The Federal Reserve implemented a quarter-point cut to its key interest rates. However, Chair Jerome Powell immediately tempered expectations for further reductions, stating, "In the committee's discussions at this meeting, there were strongly differing views about how to proceed in December. A further reduction in the policy rate at the December meeting is not a foregone conclusion. Far from it. Policy is not on a preset course." This signals a hawkish tone, suggesting a pause in easing.

Furthermore, the Fed announced a definitive end to its balance sheet reduction program, known as quantitative tightening (QT), effective December 1st. This move is seen by some as a forced reaction to market pressures rather than a controlled policy decision.

US-China Trade Truce and its Implications

A fragile one-year truce has been declared in the US-China trade war, carrying significant implications for various sectors, including rare earth minerals and soybeans. China has resumed soybean purchases, a development that benefits American farmers. The US has lowered tariffs, including a halving of tariffs on fentanyl-related products, bringing the overall average tariff rate down to 10 percentage points.

Economic Challenges: Inflation, Debt, and Data Blackout

The current economic landscape is characterized by persistent inflation at 3% and a federal deficit nearing $1.8 trillion. This places the Federal Reserve in a difficult position, caught between managing price pressures and a substantial national debt. Compounding these challenges is a "fog," as described by Powell, a government data blackout that hinders policymakers' ability to make informed decisions.

Analysis with Dr. EJ Anthony

Dr. EJ Anthony, Chief Economist at the Heritage Foundation and former nominee to lead the Bureau of Labor Statistics, provides critical analysis of these developments.

The Fed's Dilemma: Control or Cornered?

Dr. Anthony argues that the Fed is "hoisted on its own petard." He contends that the end of QT was predictable for those monitoring the repo market and the Secured Overnight Financing Rate (SOFR). The Fed's insistence on maintaining an "ample reserve regime," which involves paying banks interest not to lend, has created a situation where reducing the balance sheet could trigger a repo market collapse, similar to September 2019, and potentially lead to a full-blown financial crisis. The Fed, having made this mistake once, is determined to avoid a repeat.

The downside of ending QT, according to Dr. Anthony, is the potential for increased inflationary pressure. He also highlights that trillions of dollars remain siloed in banks, unavailable for lending, which starves the private credit market and drives up yields on mortgages, credit cards, and Treasuries. He labels this as "monetary malfeasance at the Fed."

Fractured Fed and Wall Street Bailouts

The recent Federal Open Market Committee (FOMC) vote was notably fractured, with Governor Mester advocating for a 50-basis-point cut and Kansas City President Schmid favoring no cut at all. This historic three-way dissent, seen only three times since 1990, is interpreted by some as a sign of a committee "flying blind."

Dr. Anthony believes this dissent reflects the inherent flaws in the framework established by Powell and his associates, which he argues will inevitably lead to bailouts for Wall Street. He points out that the Fed has been effectively bailing out financial institutions for years by paying them substantial amounts daily for not lending, creating a "risk-free rate of return." This practice, he asserts, starves the private market of credit, increases private market interest rates, and suppresses real growth rates, with gold prices showing the impact.

The Repo Market and Liquidity Crisis Concerns

The repo market's low levels, with over $20 billion drained and reaching the lowest point since the facility's inception, are a concern. While the Fed claims this is "normalization" and a planned move to maintain ample reserves, Dr. Anthony views it as a warning sign of an impending crisis. He reiterates that this is a "crisis of the Fed's own making" that could be unwound if the Fed chose to pivot from its new framework, instituted in 2020. He predicts that the end of QT is just the first step, with a restart of QE likely in the coming year.

Main Street's Reality: The Stressed Consumer

Dr. Anthony previously warned about the consumer being "tapped out," a sentiment now supported by recent data. Auto loan delinquencies are at their highest since 2010, affecting all income groups. Credit card delinquencies for lower-income households have surged over 60% since 2021, according to the St. Louis Fed.

The American consumer is acting as the "canary in the coal mine," with other warning signs appearing in markets like commercial real estate. The ability to "kick the can down the road" through monetary and fiscal policy has reached its limit for the consumer, who is either unwilling or unable to take on more debt. This is causing a significant slowdown in consumer spending.

Currently, the top 10% of income earners account for half of consumer spending, driven by a "wealth effect" from massive gains in asset prices like equities and real estate.

The "Everything Bubble" and Regional Bank Stress

Dr. Anthony has long warned about the "everything bubble" created by the Fed. The immense stress in regional banks, particularly those heavily exposed to commercial real estate (44% of their loans), is a prime example. Delinquency rates on office properties are nearing 10.5%, and the industry faces a trillion-dollar maturity wall of loans.

Dr. Anthony argues that Fed intervention in such situations constitutes another bailout, creating moral hazard. He advocates for policymakers to allow market discipline to run its course, even if it means some banks fail. He suggests amending the Federal Reserve Act to limit the Fed's bailout capacity, citing the 2023 regional banking crisis (SVB collapse) as an instance where the Fed made bad debt good, reinforcing the idea of a taxpayer-funded bailout.

QE and the Question of US Financing

The potential restart of QE raises questions about the US's ability to finance itself without monetary inflation. Dr. Anthony asserts that this has been the case for several years, with government spending funded by inflation, effectively devaluing dollars. He sees a continuation of this trend, albeit at a slower pace.

This devaluation has driven a movement into assets that central banks cannot print, such as gold, Bitcoin, and real estate. He also notes the rise of hard assets like cows and bulls. The Fed's future actions are expected to include yield curve control and a shift from private to government lending, which he views as detrimental in the long term. The restart of QE is necessary to prop up the Treasury market and bank reserves, maintaining the monetary framework built since 2020.

Gold as an Independent Asset

In this environment, gold is positioned as potentially the last truly independent asset. Anything the Fed cannot print is seen as a good investment due to dollar devaluation. Gold, with its significant monetary premium, is expected to appreciate, as will other assets like silver. While Bitcoin is also mentioned, its volatility is noted.

The recent conflicting movements in gold prices—rallying on the rate cut but falling after Powell's hawkish remarks and the China deal—suggests the market is weighing different factors. The market may still have some faith in the Fed's ability to manage inflation and contain geopolitical risks.

Gold's primary function is inflation protection due to its high monetary premium. Unlike industrial uses, which have a lesser impact on price, the monetary premium is speculative and can lead to significant price swings based on changing expectations. Despite past predictions of gold's demise as a safe haven, its price has more than doubled since late 2022. Central banks continue to purchase gold, further supporting its value.

US-China Trade Truce: Strategy and Outcomes

Dr. Anthony critiques the strategy and rollout of tariffs, not necessarily the tariffs themselves. He explains that the Trump administration uses tariffs for various purposes: revenue generation, pressuring nations like China to curb fentanyl flow, and protecting domestic industries or national security.

In the case of China and fentanyl, the tariffs were intended to stop the flow of the drug. China's pledge to reduce it has led to the US lowering tariffs, demonstrating the effectiveness of tariffs or the threat of tariffs in achieving policy goals.

Regarding agricultural products like soybeans, Dr. Anthony believes that the US can regain its market share. The diversification of China's supply chain to countries like Brazil and Argentina was primarily a punitive measure to gain leverage in trade talks. The underlying competitive advantages for American farmers still exist.

For rare earth minerals, where China controls over 90% of processing capacity, the one-year pause in threatened restrictions is beneficial for China and buys the rest of the world time. Dr. Anthony explains that rare earths are not found in concentrated deposits like coal, requiring extensive processing. With tax and regulatory reforms, it can become cost-effective to mine and process rare earths in the US, allowing for the reshoring of critical supply chains.

Data Blackout and Policy Vacuum

The government shutdown has led to a "data blackout," with key economic reports delayed. Dr. Anthony notes that even before the shutdown, government data had been "horrendously inaccurate." This inaccuracy has forced private market participants and the Federal Reserve to seek alternative data sources.

The deterioration in data quality has led to the development of alternative indicators and a reliance on them by major Wall Street firms. Jerome Powell himself acknowledged the use of data from the 12 district banks' economic surveys. Dr. Anthony suggests that if government statistics do not improve, they may become irrelevant.

Reforming the Data Regime

A reformed data regime would prioritize transparency and credibility. Dr. Anthony proposes expanding public-private partnerships for data collection. For the Bureau of Labor Statistics (BLS), this could involve contracting with major retailers like Walmart and Amazon for real-time price data and with payroll processing companies like Gusto, ADP, and Paychex for payroll data. This would significantly increase the number of observations and improve accuracy, contrasting with the BLS's current practice of surveying less than 2% of businesses, with less than half responding.

For the Federal Reserve, better data necessitates being "data dependent." Dr. Anthony argues that the Fed, under Powell, has not been truly data-dependent, often acting contrary to clear data signals.

Leadership and Restoring Trust

The next Federal Reserve chair will need to be a reformer, understanding both the financial plumbing and the public's loss of faith. Kevin Warsh is identified as a strong candidate who recognizes the failure of the Fed's current artificial framework and the need to return to normal monetary policy, such as reintroducing reserve ratios. Warsh is also an inflation hawk and would likely promote price stability and return loanable funds to the private sector.

A Volcker-style disciplinarian or someone who re-engineers how the Fed measures and communicates reality is needed. Warsh's arguments for data reform, tighter balance sheets, and restoring Fed independence are seen as crucial.

Impact on Gold Investors

If Warsh takes the helm, it would be beneficial for all investors, not just gold investors. Gold's primary role is inflation protection, not necessarily significant price appreciation beyond its monetary premium. Stable prices, achieved through better policy and data, would allow investors to diversify and seek higher real rates of return, reducing reliance solely on gold for protection. Dr. Anthony, a self-proclaimed "gold bug," even expresses a desire for a return to a gold-backed currency.

Market Fundamentals vs. Artificial Support

Despite interest rates above 4%, equity valuations remain high, with the S&P 500 trading around 21 times forward earnings and tech stocks at near dot-com bubble levels. The Fed's easing and creeping liquidity suggest the "bubble is still very much alive," or that markets have ceased to care about fundamentals.

There is a tight correlation between equities and bank reserves. The Fed's decision to stop QT and restart QE is aimed at increasing bank reserves, which is expected to support a bull market in equities, especially if economic growth continues and bank balance sheets expand.

The Unwinding Loop

The Fed is caught in a loop where attempts to tighten end up depleting reserves and forcing further easing. This is a consequence of the artificial monetary framework established since March 2020. The Fed's previous attempts to reduce its balance sheet in 2017-2019 led to a repo market crisis and a brief loss of control over interest rates, forcing a reversal to QE. The pandemic further exacerbated this.

Dr. Anthony concludes that under the current framework, the Fed cannot unwind its balance sheet or return it to normal. This underscores the importance of leadership like Kevin Warsh, who understands the need for radical change.

Permanent Monetization

The question arises whether the Fed is stabilizing reserves or artificially supporting financial markets, leading to permanent monetization disguised as policy management. The gold market, with its significant run-up, appears to be signaling this. Central bank purchases of gold, particularly after the US confiscated Russian dollar-denominated assets, have broadcast a message that dollar assets are no longer safe. This, combined with a growing realization of the dollar's trajectory, has driven demand for gold.