He said, “As a result, the economy can accelerate to the fastest rate of growth since the early 1980s and inflation can exceed the Fed’s 2% target as the Fed sits back and yawns. Of course, the bond market also has a say. Rapid growth and higher inflation could boost long-term interest rates even further, at which point the “bond vigilantes” could force the hand of the Fed. However, the Fed is confident that it has the tools to deal with this … especially asset purchases. “
Problems can arise here. Currently, the Fed buys $ 80 billion in government bonds and $ 40 billion in mortgage-backed securities every month. It could increase the total each month, shift purchases to longer-term government bonds, or buy fewer mortgages and more government bonds.
“We believe that in the end the Fed will change its mix of bond purchases and be pressured to hike rates before it expects to do so,” said Wesbury. “In both cases, it took some time to change the forecast before it did. And that’s a good thing, because the Fed is now wrestling with a completely different topic. In order for the Fed to operate within an economic policy that certainly resembles modern monetary theory, it must buy trillions of dollars in national debt. “
This requires big banks to buy bonds from the Treasury Department before the Fed buys them from banks by building new reserves. The banks therefore either hold the government bonds or the new reserves (deposits) that the Fed has created to buy them.
In the wake of the global financial crisis, regulators and politicians have pushed banks to hold more capital so that shareholders, not taxpayers, are eligible for credit losses. The Fed introduced the Supplementary Leverage Ratio (SLR), a rule that requires banks to hold 5% capital on ALL of their assets – including government bonds and reserves.