U.S. Treasury Becomes a 'Shadow Central Bank', Eroding the Independence of Federal Reserve Monetary Policy

This trend puts the Federal Reserve in a dilemma: raising interest rates will immediately increase government financing costs, creating dual resistance from fiscal and political fronts, fundamentally challenging policy independence.

Written by: Bao Yilong, Wall Street Insights

The U.S. Treasury is continuously expanding the scale of Treasury bill financing, bringing its functions closer to that of an actual currency issuance institution, and gradually intervening in the Federal Reserve's domain through quasi-monetary policy operations.

On September 2, Bloomberg macro strategist Simon White pointed out that this trend will structurally raise inflationary pressures, weaken the independence of Federal Reserve policies, and expose market stability and real returns on stocks and bonds to greater risks.

Currently, Treasury bills account for 22.7% of the U.S. outstanding debt balance, exceeding the informal 20% cap set by the Treasury. Excluding the portion held by the Federal Reserve, this ratio rises to 24.1%.

White believes that as the fiscal deficit continues to expand, this ratio is expected to rise further, and the policy interest rate will no longer just be a core variable of monetary policy but will become a key anchor point for determining fiscal stability.

This structural shift means that if the Federal Reserve attempts to control inflation by raising interest rates, it will face stronger political and fiscal resistance. Raising interest rates will directly increase the government's financing costs, effectively tightening fiscal policy and exerting reverse pressure on monetary policy.

White bluntly stated that in the context of continuously expanding Treasury bill issuance, finding an interest rate level that simultaneously meets inflation targets, maintains financial stability, and does not let government borrowing costs spiral out of control may be an impossible task.

From Financing Tool to 'Shadow Currency': The Evolution of Treasury Bills' Role

Treasury bills have traditionally been a routine tool for short-term financing by the U.S. government, but White points out that the Treasury is intentionally replacing long-term bonds with Treasury bills to absorb the financing demands arising from the expanding fiscal deficit.

From the Treasury's own perspective, this strategy has clear financial logic:

• Short-term debt financing costs are usually lower than long-term debt, and Treasury bills appeal to a broad pool of funds that prefer low-duration assets;
• Compared to long-term bonds, Treasury bills have a smaller fund diversion effect on bank deposits, helping to maintain market liquidity and real economy spending;
• Additionally, this path also somewhat avoids the political sensitivity of openly implementing financial repression, although the Treasury's expansion of the debt buyback plan has been seen as a substantial step in that direction.

However, in White's view, Treasury bills are no longer just ordinary short-term financing tools. According to the monetary hierarchy theory proposed by Perry Mehrling, at the top of the financial system are Federal Reserve reserves, followed by bank deposits, repurchase agreements, and shares of money market funds, which are considered 'shadow currencies.'

Due to their very short maturities and extremely low valuation uncertainty, Treasury bills typically enjoy zero discount treatment in the repurchase market and can be reused multiple times through a collateral rehypothecation mechanism without losing value.

White points out that this makes Treasury bills functionally closer to money itself, a liquidity tool that can be used for final settlement.

The Amplifying Effect of the Rehypothecation Mechanism: Quiet Expansion of Quasi-Monetary Supply

White particularly emphasizes the key role of the rehypothecation mechanism in this process.

In the repurchase market, traders can obtain collateral from their own Treasury holdings or borrow through reverse repurchase operations and then re-pledge the latter to other counterparties.

According to a 2021 academic study cited by Bloomberg, from 2015 to 2021, U.S. Treasury collateral was rehypothecated an average of three to five times; during other periods, this number has been estimated to be even higher by different sources. This means that traders are effectively continuously amplifying the amount of available effective collateral in the market.

White points out that for long-term Treasury bonds, each round of rehypothecation gradually erodes the actual value of the collateral due to discount rates; however, Treasury bills, with a zero discount rate, can be repeatedly pledged without value loss. This characteristic allows Treasury bills to continuously replicate themselves within the financial system, creating a liquidity expansion effect akin to money.

Historically, an increase in the proportion of Treasury bills to total outstanding debt often precedes the emergence of structural inflation.

White believes there is a reasonable transmission path behind this: increased liquidity pushes up asset prices, strengthens the wealth effect, while artificially lowering capital costs, ultimately transmitting to the real economy and raising the overall price level.

Federal Reserve in a Dilemma, Policy Independence Fundamentally Challenged

White believes that the expansion of Treasury bill issuance fundamentally constrains the Federal Reserve's policy space.

As more public debt is directly linked to short-term interest rates, every rate hike by the Federal Reserve will immediately increase the government's interest expenses, equivalent to automatically tightening fiscal policy. This mechanism objectively creates political pressure, making it more difficult for the Federal Reserve to act decisively when inflation rises.

White directly points out that as the proportion of Treasury bills continues to rise, "the Federal Reserve may no longer be able to optimally set policies to achieve inflation targets in the future."

At the same time, the increase in Treasury bill supply may also trigger vulnerabilities in the short-term financing market. If the new supply pushes Treasury bill yields upward, money market funds may shift funds from the repurchase market to Treasury bills, thereby reducing liquidity supply in the repurchase market.

White particularly notes that in the current context where the sum of Federal Reserve reserves and reverse repurchase tool scales is relatively low compared to GDP, this migration of funds poses a significant risk of tightening in the short-term financing market.

From a financing structure perspective, the Treasury itself will also face higher vulnerabilities. The issuance of Treasury bills means more frequent and larger auctions, and any rise in inflation expectations will immediately reflect in borrowing costs. Even if the Treasury intends to reduce long-term debt issuance, if the term premium rises significantly, long-term financing costs may ultimately increase instead of decrease.

White's conclusion is rather pessimistic: as the proportion of Treasury bills expands, the policy interest rate will simultaneously bear the dual functions of monetary policy and fiscal stability. Finding a balanced interest rate level that satisfies inflation targets, financial stability, and fiscal sustainability is likely to be an unsolvable problem.

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