Submitted by Taps Coogan on the 23rd of July 2019 to The Sounding Line.

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Luke Gromen, founder and president of Forest for the Trees, recently spoke with MACRO Voices’ Erik Townstead and discussed his theory that the Fed is going to cut interest rates because the US commercial banking system is running out of sufficient dollar liquidity to finance growing government deficits. We have featured a number of interviews with Mr. Gromen on this topic because they speak to a theme we have written about frequently here at The Sounding Line. Namely that central banks are claiming that monetizing government deficits through QE and artificially low interest rates isn’t as bad as it sounds because they are doing it to stimulate the economy, not to keep governments solvent. However, as Mr. Gromen discusses at length, US federal deficits are now getting so large that without central bank monetization, there likely wouldn’t be enough dollar liquidity to fund the deficits.

Some excerpts from Luke Gromen:

“Virtually no one is discussing the real reason for the Fed cutting rates, which is that US fiscal deficits are increasingly being financed by the US domestic private sector and… the true message of the Fed Funds rate going over Interest on Excess Reserves (IOER) back on March 20th, 2019 and staying there ever since is that the US private sector does not have enough balance sheet to finance US government deficits without the Fed’s help. In our view, the Fed is cutting rates to provide that help to the private sector…”

“(Banks) aren’t lending into the Fed funds because the so-called excess reserves aren’t excess reserves at all. They’ve become required reserves effectively. What we think is happening is that the banks don’t have the excess reserves because they or their depositors have shifted cash into the treasury market either directly or via investment funds or government money market funds…”

“…Fed funds over IOER is a sign lack of US bank balance sheet capacity and that then begs the question: why is this happening? If we look at what primary dealer holdings of treasuries began doing in Q4 2018, to us the answer jumps off the page. In Q4 2018, primary dealer holdings of treasuries rose at a $500 to $600 billion annual rate. In short, in Q4 2018 the US government was being financed in no small part by primary dealers…”

“…The US banking system is increasingly choking on federal deficits. To us, the Fed Funds over IOER is a sign that the US banking system and by extension the US private sector, is running out of balance sheet capacity to finance US government deficits without help from the Fed…. This is why so many analysts are confused about why the Fed is cutting rates when recent economic data looks pretty decent… It’s not about the economy. It’s about money markets demanding the Fed begin helping the US banking system finance US government deficits.”

When does the swelling national debt go from an abstract problem that lingers in the future, to an immediate crisis? When investors and banks no longer have enough liquidity to absorb ever more debt and the Fed doesn’t monetize. Investors and banks are likely already arriving at that point and so the Fed must monetize, and they will. Based on the trajectory of deficits before the recent budget deal that increases the deficit by hundreds of billions of dollars, the US needed to find a new buyer of government debt equivalent in size to China and Honk Kong’s total accumulated treasury holdings every single year. Recall that the last time the national debt was this high, the Fed pegged long term interest rates at 2.5% for nearly a decade to prevent a debt crisis during World War II.

Of course, in our bizzaro world of ‘bad news is good news’ the fact that federal deficits are spiraling out of control is probably ‘good news’ for financial markets because everybody loves low interest rates and QE…

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