Inflation, The Deficit & Why the Dollar Stays King with Benn Steil | The Real Eisman Playbook Ep 81

Benn Steil · Council on Foreign Relations

Hot inflation data makes a Fed rate hike at the upcoming meeting likely, a move markets had not expected.

The inflation print came in above expectations (3.7% versus 3.6%). Steil says futures-market odds of a hike at the Fed's late-month meeting had moved from below 50% to above 50% in two days, which he calls material. He says the surprise leaves a possible majority of the committee in favour of hiking, which puts Fed Chair Warsh in a bind between dissenting and angering Trump, who appointed him.

“there looks now like there may well be a majority for hiking rates.”at 4:19

Benn Steil · Council on Foreign Relations

The Fed's large balance sheet poses no problem for controlling rates, so QE criticism is misplaced.

Steil disagrees with the view that quantitative easing was overdone and that the balance sheet is a distortion. He says the evidence shows the Fed can control interest rates well above the zero bound using interest on reserves, the interest it pays banks to park money at the Fed. The balance sheet being much bigger than before the financial crisis is in no way a problem for controlling inflation.

“All the evidence we have right now is that the Fed is perfectly capable of controlling interest rates when we're well above the zero bound”at 6:41

Benn Steil · Council on Foreign Relations

The Fed is a poor forecaster, so formal forward guidance should be dropped as it locks officials in.

Steil says the empirical evidence is overwhelming that the Fed is bad at predicting the future. Over many decades it has been systematically worse than blue-chip private-sector forecasters, including by the findings of Fed studies. Forward guidance assumes the Fed has better information than the market. Since its forecasts are no better, Fed officials announcing how they will vote can lock themselves in and create problems, so he agrees with dropping formal forward guidance.

“First, the empirical evidence is absolutely overwhelming that the Fed is not good at predicting the future.”at 7:27

Benn Steil · Council on Foreign Relations

Bessent's $6bn long-end Treasury buyback is too small to move rates, so the market treats it as a head fake.

Bessent's plan sells short-term Treasuries and buys long-dated ones, about $6bn. Steil says it is about 0.016% of the Treasury market, and the deficit is roughly $40T. Calculations of the ammunition available show it is overwhelmed. The market breach lasted less than a day. Because the buyback is funded by issuing more short-term debt, it repeats the kind of operation Bessent criticised his predecessor for. Steil says the Japanese yen precedent also shows the approach fails.

“And it did not work. Not even close.”at 11:19

Benn Steil · Council on Foreign Relations

Rate-insensitive buyers of Treasuries fell from 76% to 43%, so rising debt will push rates up further.

Twenty years ago, 76% of Treasury buyers were rate-insensitive, mainly central banks buying Treasuries as reserves regardless of price. That share is now 43%. Each additional dollar of debt has to attract more rate-sensitive investors, who need higher yields. Steil calls this an accelerationist effect: the investor base gets worse as the deficit grows, which pushes interest rates up.

“the more debt we issue, the more interest rate sensitive investors we have to attract into the market to buy”at 27:10

Benn Steil · Council on Foreign Relations

Inflation is persistent and not coming down, so the Fed must act to keep expectations anchored.

Steil says a temporary oil shock could be looked through, but inflation has been persistent and is clearly not falling. Inflation came in at 3.7% against 3.6% expected, and he says upside misses matter. Although longer-term inflation expectations have not risen significantly, the Fed is worried that delay would let expectations become unmoored, making its job harder later.

“But inflation's been persistent. It's clear that it's not coming down. Although we haven't seen any significant rise in longer term inflation expectations, the Fed is genuinely concerned that if they don't move now”at 2:59

Benn Steil · Council on Foreign Relations

Japan's yen intervention was funded by selling about $88bn of foreign securities, mostly Treasuries, despite Bessent's loan.

Bessent worried that Japan was selling Treasuries to intervene and push up the yen. He lent Japan money through a Fed facility so it would not have to sell them. Bessent declared victory because the yen did rise. A month later, Japanese data showed the Ministry of Finance had spent about $99bn intervening and had sold about $88bn of foreign securities, nearly all Treasuries. Steil says this shows Bessent's logic did not work.

“the Japanese Ministry of Finance had intervened in the currency markets to the tune of about $99,000,000,000 And they had sold $88,000,000,000 worth of foreign securities, all or almost all of that Treasuries.”at 13:27

Benn Steil · Council on Foreign Relations

There is no credible alternative to the dollar; reserve diversification goes to gold, not rival currencies.

Steil calls the dollar the winner of an ugly dog contest, since currencies are always traded against other currencies, so a loss of faith would not clearly send money elsewhere. Major central banks have not broadly sold dollars for other currencies. They have bought gold instead. The yuan's CIPS settlement rose when Iran tolled the Strait of Hormuz and demanded RMB, but payments went back to SWIFT after the ceasefire. The euro is not an alternative either, given the lack of a eurozone sovereign debt market.

“the best way I've heard the US dollar described as the winner of an ugly dog contest.”at 15:19

Benn Steil · Council on Foreign Relations

Central banks and China and Russia are building gold reserves, which perform as well as the dollar in crises.

Central banks have bought gold instead of selling dollars over the past 20 years. Steil says countries have learned that gold does well in times of stress, so it is roughly as good as the dollar as a crisis reserve, and some would say better. China and Russia have been building gold stocks and moving them to safe locations, and the Dutch repatriated their holdings from the New York Fed. Sanctions on dollar-based finance, such as on Iran, add to the incentive to hold reserves outside the dollar system.

“countries have learned that during a crisis, gold is approximately as good, some could argue, better than the U.S. Dollar, because gold tends to do well during times of stress.”at 18:13

Benn Steil · Council on Foreign Relations

AI-driven demand for capital is pushing up Treasury yields, with the US competing against AI infrastructure for funding.

Steil's defence of Treasury Secretary Bessent is that the US is a temporary victim of its own success. The economy is doing well, AI is exploding, and that creates huge demand for capital. That pushes up Treasury rates, which feed through to the global economy. The Treasury is competing with AI infrastructure and with other governments for global investment, so rates rise everywhere, especially in countries with poor fiscal positions.

“AI is exploding, and there's a huge demand for capital.”at 22:52

Benn Steil · Council on Foreign Relations

The US deficit trajectory is ugly, with no political will to cut and Treasury optimism about growth unsupported.

The US deficit is running about 6% of GDP. Steil says neither Congress nor the executive branch has any serious willingness to cut anything. The last serious bipartisan attempt was Simpson-Bowles under Obama, which failed to get a majority and was abandoned. Now the Treasury Secretary says not to worry and that the US will grow out of it, but the numbers do not bear that out. The deficit is also crowding out investment and pushing rates up.

“there's no longer any serious willingness in Congress or in the executive branch to [...] cut anything.”at 23:56

Benn Steil · Council on Foreign Relations

France's bonds will be priced like corporate debt, since investors demand compensation for its poor fiscal position.

France has a very poor fiscal position and no political will to deal with its large deficits. Steil says it is in an even worse position than the US, since virtually all of its bond investors are rate-sensitive. There is no eurozone sovereign debt market, so German bonds are the closest thing to a safe asset. Investors have to be convinced they will be compensated enough for holding French debt, so French government bonds are treated like corporate bonds rather than risk-free assets.

“You and I grew up calling the U.S. Treasuries a risk free asset. Nobody is going to call French government bonds a risk free asset.”at 28:02