Stablecoins are becoming an instrument of US fiscal policy

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Unless something goes very wrong at his confirmation hearing, Kevin Warsh will be the next chair of the Federal Reserve. Unfortunately, he inherits a slippery portfolio: He will need to ensure price stability and maximum employment while battling the Fed's waning relevance.

Of course, the U.S. central bank is one of the more significant institutions in the global economy. Its decisions on the federal funds rate, swap lines, balance sheet and more can have a far-reaching impact on currencies and entities around the world.

Yet anyone following monetary policy and macroeconomic indicators of late will have noticed that the level of the federal funds rate does not have a notable impact on either bond yields or economic activity. Since the beginning of the easing cycle in September 2024, it has been cut by 175 basis points. Over the same time frame, the 10-year Treasury yield has risen by 60 basis points. Even the yield on two-year Treasury notes, in theory more sensitive to movements in the official rate, is only 5 basis points lower. The message isn't getting through to the bond market.

What's more, an index compiled by the Chicago Fed shows that financial conditions are looser now than before the Fed started hiking rates in March 2022. Annualized GDP growth has averaged around a reasonable 2.5% since then, even taking into account two negative quarters. The unemployment rate has ticked up since the post-pandemic low, but it is still well below the pre-pandemic average.

In sum, it's reasonable to question just how much monetary policy matters in the modern economy. In 2023, the rate of year-on-year growth in commercial bank lending slowed in response to the Fed's tightening (while remaining positive), with no discernible impact on the rate of growth of real GDP. Arguably, fiscal policy — that is, government spending — has been a stronger driver of activity than bank credit.

But I'm not here to talk about how the macroeconomy works these days, nor whether fiscal dominance can be maintained.

No, I'm here to point out that stablecoins are an integral part of this conversation.

To see how, let's step back and look again at what backs stablecoins: Mainly, it's short-term Treasuries and related instruments. Hold that in mind for a second.

Now, let's pivot and look at the bank lobby's fury at the possibility that stablecoins earning rewards could siphon off deposits. "This will hurt bank lending," they exclaim. "The economy will suffer!"

While that is debatable (deposits reallocate rather than disappear as dealers in Treasuries have to deposit their increased proceeds somewhere), the underlying issue is one of economic impact.

Meanwhile, the U.S. Treasury is positioning for greater influence.

This includes using the distribution of government debt issuance to manage the yield curve. Around 10 years ago, the weight of notes (2-10 years maturity) was around 65% and that of bills (less than one year) was roughly 10%. Today, the weightings are 55% and 20%, respectively. All else equal, less issuance at the long end pushes up the price and brings down the yield, relevant since mortgage rates are linked to the 10-year Treasury. But more issuance at the short end, all else equal, pushes down the price which results in higher yields — this may give the government greater refinancing flexibility and help keep the repo market liquid, but higher yields mean higher interest payments which is not great for the deficit.

Of course, the yield impact of increased short-term issuance could be offset by more demand for short-term Treasury bills. Put differently, the higher yields from more supply could be brought down by more demand. But investors often prefer longer-term Treasuries for their better yield and for the lower rollover risk and maturity hassle.

So, where could more short-term demand come from?

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You got it. From stablecoins! Greater global demand for dollar-backed stablecoins should translate into more demand for short-term Treasury bills. That, in turn, should keep short-term yields either at current levels or hopefully lower, even in the face of higher issuance.

So, zooming out, we have bank lobby groups warning that stablecoins will siphon off deposits and reduce bank lending, essentially rendering monetary policy less effective. And we have the Treasury department looking for new buyers to absorb the increasing issuance of short-term government bonds, essential for an effective fiscal policy.

Monetary vs fiscal policy. You see the tussle here?

While the U.S. central bank insists that independence is essential, the U.S. Treasury department would presumably not be unhappy if the Federal Reserve ended up with less influence on the economy.

Put differently, the Treasury Department needs new buyers of short-term Treasuries. One way to get them is to encourage the global adoption of dollar stablecoins and the corresponding purchase of authorized reserve assets. If that means that bank lending becomes less effective in determining monetary policy, undermining Federal Reserve influence, then so be it.

There's a reason Treasury Secretary Scott Bessent is publicly predicting $3 trillion of stablecoin market capitalization by 2030, a tenfold increase from current levels. (I've written before about how that could be hard to achieve, but for the sake of theory, let's go with it.)

This is all particularly relevant now that we know Kevin Warsh is President Trump's nominee to chair the U.S. central bank. Warsh and Bessent have a close professional relationship, both have worked for famed hedge fund manager Stanley Druckenmiller. What's more, both are blockchain enthusiasts.

While Warsh may have changed his views a few times on the threat of inflation, he has been consistent on the need to reduce the Fed's balance sheet, even though research shows that the removal of liquid assets could lead to higher volatility in the repo market, and that increased Treasury bill issuance could help offset this.

So, the potential role of stablecoins in the management of the U.S. economy starts to take shape. It doesn't make monetary policy irrelevant. But it does support a greater influence of the U.S. Treasury and its fiscal policy.

And you thought perhaps that stablecoins were just a technological innovation?