The U.S. Treasury is becoming a "shadow central bank," and the Federal Reserve's monetary policy independence is facing erosion.

The U.S. Treasury continues to expand the scale of Treasury bill financing, making its function increasingly approach that of a de facto currency issuer, and is gradually intervening in the Federal Reserve’s territory through quasi-monetary policy operations.

On September 2, Bloomberg macro strategist Simon White pointed out that this trend will structurally increase inflationary pressures, weaken the Fed’s policy independence, and heighten risks to market stability and real returns on stocks and bonds.

Currently, Treasury bills account for 22.7% of U.S. outstanding debt—a figure that exceeds the Treasury Department’s informal limit of 20%. If the portion held by the Federal Reserve is excluded, this ratio climbs to 24.1%.

White believes that, as fiscal deficits continue to expand, this proportion is expected to rise further. At that point, policy rates will not only be a core variable for monetary policy but will also become a key anchor for fiscal stability.

This structural shift means that if the Federal Reserve tries to control inflation through interest rate increases, it will face stronger political and fiscal resistance. This is because raising interest rates directly increases the government’s financing costs, effectively tightening fiscal policy automatically and creating a reverse pressure on monetary policy.

White bluntly stated that against the backdrop of a continued expansion in Treasury bill issuance, to find an interest rate level that simultaneously meets inflation targets, maintains financial stability, and avoids government borrowing costs spiraling out of control, he said:

This may ultimately be an impossible task.

Treasury bills have always been the U.S. government’s conventional short-term financing tool, but White points out that the Treasury Department is now deliberately using bills to replace longer-term bonds to absorb the increased financing demand from a growing fiscal deficit.

From the Treasury’s perspective, this strategy has a clear financial rationale:

• The cost of short-term borrowing is usually lower than long-term debt, and Treasury bills appeal to a broad pool of funds favoring low-duration assets;
• Compared with longer-term bonds, Treasury bills have a smaller fund-diverting effect on bank deposits, which helps to maintain market liquidity and expenditures in the real economy;
• In addition, this path also to some extent avoids the political sensitivity of openly implementing financial repression, although the Treasury’s expansion of its Treasury buyback program has already been considered a substantial step in that direction.

But in White’s view, Treasury bills are no longer just an ordinary short-term financing tool. According to Perry Mehrling’s hierarchy of money theory, at the top of the financial system sit Fed reserves, followed by bank deposits, repo agreements, and money market fund shares—so-called “shadow money.”

Due to their ultra-short maturity, and extremely low valuation uncertainty, Treasury bills typically enjoy zero haircuts in the repo market, and through the collateral rehypothecation mechanism, can be repeatedly reused without loss of value.

White points out that this makes Treasury bills increasingly functionally close to money itself—a liquidity tool suitable for final settlement.

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

In the repo market, dealers can obtain collateral from their own treasury holdings, or borrow through reverse repos, and then re-pledge the latter to other counterparties.

According to a 2021 academic study cited by Bloomberg, between 2015 and 2021, U.S. Treasury collateral was rehypothecated an average of three to five times; in other periods, this number has been even higher according to different sources. In other words, dealers are continually amplifying the amount of effective collateral available in the market.

White notes that for longer-term Treasuries, each round of rehypothecation gradually eats away at the collateral’s actual value due to increasing haircuts; but since Treasury bills have a zero haircut, they can be re-pledged repeatedly without value erosion. This characteristic allows Treasury bills to continuously replicate themselves within the financial system, producing a shadow money supply expansion effect.

Historically, an increase in the proportion of Treasury bills to total outstanding debt has often preceded periods of structural inflation.

White believes there is a logical transmission path here: increased liquidity pushes up asset prices, strengthens the wealth effect, artificially lowers the cost of capital, and ultimately transmits to the real economy, pushing up the overall price level.

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

As more public debt becomes directly tied to short-term interest rates, every rate hike by the Fed immediately increases the government’s interest expenses, which is equivalent to an automatic tightening of fiscal policy. This mechanism objectively creates political pressure, making it harder for the Fed to act decisively against rising inflation.

White directly points out that as the share of Treasury bills continues to rise, “in the future, the Federal Reserve may no longer be able to optimally set policy to achieve its inflation goal.”

At the same time, the increased supply of Treasury bills could also trigger vulnerabilities in the short-term funding market. If new supply drives up Treasury bill yields, money market funds may shift funds from the repo market to Treasury bills, thereby reducing repo market liquidity supply.

White especially notes that given the currently low combined size of Fed reserves and reverse repo tools as a share of GDP, the risk of short-term funding market tensions arising from this capital migration is particularly noteworthy.

On the funding structure front, the Treasury itself will also face higher vulnerability. Issuing more Treasury bills means more frequent and larger auctions, so any rise in inflation expectations will be reflected immediately in borrowing costs. Even if the Treasury tries to limit long-term issuance, if term premiums surge, long-term borrowing costs may still rise rather than fall in the end.

White’s conclusion is rather pessimistic: as the share of Treasury bills expands, policy rates will have to shoulder both monetary policy and fiscal stability roles. And among the inflation target, financial stability, and fiscal sustainability, finding a balanced interest rate level that fully satisfies all three may be an unsolvable dilemma.