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Busch: Coming To Their Fed Senses?

Yesterday and today, we have members of the Federal Reserve hitting the airwaves with consistent warnings over the US fiscal state.

Apparently, the bond market vigilantes forcing the US Tsy 10 yr yield up to 3.75% last week woke up our esteemed financial colleagues to the danger of a $1.8 trillion deficit. Under the section entitled " Fiscal Policy in the Current Economic and Financial Environment", Bernanke lays out the details, "As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II."

Then in perfect Bernanke speak form, he warns, "Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs."My translation: "I can't keep up with buying your debt when you keep increasing the amount of debt you are issuing. Rates will go up and there's nothing I can do about it."

Federal Reserve Bank of KC President Thomas Hoenig provided a simpler explanation, "I suggest strongly that we need to be alert to the markets' message and begin in earnest to bring monetary policy into better balance before inflation forces our hand... Starting from where we are today, it is clear that interest rates must rise. As the economy recovers, even at a modest pace, resource demands will begin to increase."President of the Cleveland Fed Sandra Pianalto echoed these remarks today.

As an example of the extremes of this spending, US government spending on benefits will top $2 trillion in 2009 or 16.2% of personal income according to the BEA. This is the highest percentage since the government began compiling records since 1929. USA Today carries the story which details unemployment insurance, social security, and food stamps as the biggest drivers of the increase.

The massive debt also scares the heck out of our biggest lenders and holders of US dollars/Treasuries. While many people scoffed at the Chinese for advocating a new reserve currency, they missed the point of the event. The Chinese are going to change they way they manage their reserves and how they manage their trade in regards to currencies. Last week, the Chinese and Brazilian officials discussed how they could work around the US dollar. Today, the Chinese and Malaysians did the same.

Back to the Fed folks, why are they doing this? When rates back up 80% in 3 months, you take notice. Higher borrowing by the US government (and others) competes for money, the price of money goes up, and this reduces the profitability of private sector companies. It reduces and chokes off growth before growth can reach its potential. The significant drop in mortgage applications in April and May is the first warning sign.

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Andrew Busch
Andrew Busch

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Andrew B. Busch is Global FX Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece andreach him here and you can follow him on Twitter athttp://twitter.com/abusch .