This topic will be focused on discussing the developments and the possibility of a fiscal dominance scenario in the US
Since government debt and fiscal deficits continue to grow very rapidly, and CBO projections don’t point to a change in these.
I think is appropriate to consider the implications of what a scenario where the FED loses its independence could mean for the economy and markets.
Lyn Alden always gives very good arguments. I would recommend reading it complete if possible.
This one is the first I have read that has made me think a recession could be extremely mild and much later on than expected. But more importantly inflationary pressures in the economy will not disappear either as everyone is expecting, and hence higher rates. I am trying to think of counterarguments, but I have found it difficult
Her argument:
Higher rates don’t help much or have a limit in fighting fiscal-driven inflation. When debt is above 100% GDP, increasing fiscal deficits are inflationary and stimulative. Higher rates will only increase the interest expenses that get to the economy and ironically could increase inflation.
“In 2023 there are signs that the interest rate portion of the Federal Reserve’s tighter monetary policy may have gone full circle, and that its ongoing inflationary affects on the fiscal side are starting to compete with those disinflationary affects on the private sector. Homeowners and large corporations are locked in with fixed rates, and further rate hikes end up pouring more and more fiscal deficits into the economy by raising the Treasury’s average interest expense, which is ironically stimulatory to a certain degree.
If we summarize the moving parts together for the United States, what we potentially get is a longer and grindier type of inflation, and an economy that remains at stall-speed or enters a mild recession rather than experiencing a boom or a bust just yet. The 2022 spike in consumer prices came after massive 2020/2021 money supply growth. Now, we have a less impactful but more persistent type of large deficit spending, so we shouldn’t expect 9% inflation but we also have to be careful about predicting massive deflation.”
Interview explaining her argument: https://www.youtube.com/watch?v=O-Ns8CrkunI
I finally read the article and think Lyn Alden does a very good job explaining things. We should even start collecting articles like that as they might help us to explain certain things to people at a later stage.
While a lot of correlations cited are correct I personally do not think that there will be any large inflationary impacts from higher rates given the following arguments:
Therefore I think that additional interest payments are going mainly toward asset price valuations but not mainly toward consumption and inflation. Even if we assume that 10% of 500 billion additional interest payments go towards consumptions (and that’s a high estimate) there would be only a 50 billion inflationary impact which dwarfs against an updated projected budget deficit of more than 1.5 trillion per year in the next years.
To be honest this is one of the topics that I cant be certain one way or the other until I can see it for myself. In my opinion, you are oversimplifying it, and making an assessment based on that.
Fiscal dominance is much more complex than just interest payments increasing, and its core issue comes from the increasingly larger debt/deficits that need financing and get out of control. Usually, the central banks are left without any option but to do it themselves, meaning the central bank’s target is force to become keeping the government from bankruptcy, and not inflation/unemployment/growth.
https://www.cato.org/blog/fiscal-dominance-fed-complacency
Her argument in the article is that the FED increasing rates are actually contra-productive or ineffective in a fiscal dominance environment, and can exacerbate instead inflation and increase deficits (more financing needed), but this is not the core problem. Her view is also a long-term view, and not a short-term one.
Even if the inflation coming from high rates is not significant, the one coming from a scenario of the FED monetizing the deficits could be. But as a mentioned, I don’t have enough knowledge to have certainty one way or the other. I just know the US debt/deficits indeed look unsustainable, and the foreign appetite for treasuries has been decreasing, not sure there is enough balance sheet capacity internally for the huge supply in coming years.
Interesting article.
I agree that rising government deficits in the united states which are caused by an increasing political divide & popularism on both sides is the root problem and that this fiscal spend is going to cause a certain degree of inflation and will hurt the value of the dollar.
This is actually one of my main reasons to be bullish on equities as this spend is going to cause increased demand from which mainly U.S. companies are able to profit + holding assets like equities will serve as a protection from USD inflation. See also: Dollar liquidity during quantitative tightening and record U.S. debt levels - #9 by moritz
I also agree that there is the risk of fiscal dominance as described in the article that central banks could be pressured into solving fiscal problems. Starting from 2022 the Fed certainly surprised some market participants by hiking strongly and proving it’s independence for now but this could change again.
When it comes to rising interests and spending I think the effects on saving accounts of consumers will be the most interesting to observe (if and when rates start to eventually increase there), I do not believe though that interests will be able to compensate for past inflation and overall purchasing power will be lost.
The very specific argument of Lyn that higher interest payments from treasuries could have a meaningful impact on inflation stops short of going in-depth imo (she explains well different groups that hold treasuries but does not provide information on how much treasuries each of those groups hold) and does focus too much on the amount of additional interest rates that need to be paid in the very long term. (both short and longterm interest payment numbers are not relevant for inflation if you run the math on them - given the assumption holds that only a small portion of those payments will find it’s way into consumption)
While the Fed cannot solve fiscal problems and higher interest rates do certainly make the deficit problem worse it could also provide much-needed pressure on politicians to rethink their spending and stop relying on central banks.
Yes, I do agree with you, sustained inflation will be bullish for equities, at least relative to the dollar. But I also don’t think it will be just an easy way up, and there will be a lot of volatility, as the market ingest that this could be the new normal.
I also don’t know if it’s positive for all sectors, or if there are sectors that this could actually be harmful, as I have not studied much 1940s yet. Or other countries that this has happened.
I also did mentioned that this is the only argument that has make me think that a recession could probably be mild because deficits of this magnitude are still stimulative, and we can have more of a stagflation environment from now on.
But while long term I see the probability of this “fiscal dominance” happening being high, I have less or no certainty about the effects in the short term, and the impact in this current cycle.
Because I have also think that the government could try to attract financing first from the private sector by increasing more and more the debt yields. Sucking liquidity out of private markets into treasuries, bad scenario for equities. However this probably has a limit and can’t be done forever.
So short term (1-5 years) I would say I don’t have certainty yet which is the most likely scenario, but long term seems inevitable that the FED will have to step in at some point and monetize deficits, and devalue the dollar.
It would be nice to think that this will make an impact on politicians, but I don’t think it will. It is highly impopular to cut spending at the levels needed, and neither partly will be willing to sacrifice themselves to do it.
Between the 2 solutions: less fiscal spending and inflating the debt. The latter is imo much more likely.
And while I don’t think the impact of interest expenses are the main point, if you want to measure it, you would also have to take into account the indirect impact of the wealth effect in spending, and the additional spending in commodities/goods that foreign countries could do if they are getting more dollars, and not only the direct impact in US individual checking accounts.
Fair point. Cash demand from increased government bond issuances is a bearish argument for equities, bonds, crypto, etc. if the money supply is not increased and the Fed is continuing with QT.
I think we have to keep considering the possibility that the Fed will be able to defend its independence even if people got very used to the Fed stepping in and solving every problem and the chances of a truly independent Fed might be low.
In this scenario, politicians wouldn’t have the option to monetize deficits and need to change course on spending as money would become real again and the option to simply keep printing and spending would disappear.
I also wonder if there will be any measurable effect on popularism from both sides once the thread of a Trump reelection disappears (Either because Trump is defeated or elected in 2024) or after Trump leaves politics once and for all. Given how divided the country is I am not very optimistic about it.
Yes, I would not give it a zero probability, but IMO is one of the lowest probable scenarios.
Even if the FED sound very determined to not monetize debt, if at some point there is a crisis with the US debt, the FED will most likely be going to step in, because no way they will let the US near any type of default or treasury market disruption. The politicians know that, creating an incentive to do nothing, waiting for the FED reaction.
This is a really good interview to get an first understanding of the fiscal deficit currently being stimulative.
Lyn Alden (and Luke too) imo has been 1 of the few pointing this out even before everyone was talking about this.
This is also similar to Ray Dalio’s thesis of the long-term debt cycle, where the US is closer to entering a debt spiral cycle where they can’t get out of it without default or money printing.
And IMO we could be starting to see some of the effects of the deficits being so high outside a recession in inflation, the economy, and risk assets.
And the FED is even talking about slowing QT because they are afraid of liquidity issues due to the high level of debt that needs to be absorbed by the markets.
I also think if the US avoids a recession completely, it is mainly because of this reason. I admit I don’t understand in great depth the consequences on the economy having permanently high fiscal spending and deficits. And it could be something I have maybe underestimated.
I will need to put more research into this.
Just a few points of their opinions:
This is the gold chart they reference in the video, where it’s breaking the usual relationship with rates.
After going a bit more in-depth into the options and possibilities of Donald Trump, I am maintaining my initial assessment that the likelihood of Trump influencing rates is very low
My arguments:
'I’m not surprised. I think holding the rates at this point was the right thing to do."
While I believe the risks to Federal Reserve independence are more elevated under the Trump administration, largely due to his unpredictability. I still assign a relatively low probability (~15%) to the removal of Chair Powell before 2026. Maybe he can try, but the probability of succeeding I think are low.
However, even if Powell remains in his position, his current term ends in May 2026. That means the coming months will likely still be filled with speculation over his potential successor, and what does this mean, keeping volatility around this topic elevated.
A more tangible risk, in my view, is that Trump could preemptively appoint Powell’s replacement months before his term concludes, effectively creating a “shadow Fed Chair.” According to Bessent, there are already discussions about interviewing candidates this fall.
Risk according to Jim Bianco: That is, appoint Powell’s replacement months earlier. Then, let the nominee regularly go on financial TV (BB, CNBC, FBN, etc.) and “armchair QB” and critique every Powell speech and decision, thereby undermining his authority. Should we listen to the guy leaving next May (Powell) or the person who will be Fed Chair next May?
Sounds like the Shadow Fed Chair is coming this fall.
So, Trump will be able to elect a new FED chair within a year, and this could come with changes in the FED despite Powell being fired or not. Since the FED chair is still only one vote, I don’t necessarily think this will mean rate cuts and money printing will come without making sense, but it could create a more political FED, especially since the chair is the one who gives more important speeches.
But I think the more acute risk, which is the possibility of firing Powell and sending warning signals to markets about the safety of U.S. institutions, is currently quite limited
My arguments for why the likelihood of Powell leaving/resigning currently is low:
Video (from last Wednesday April 16 ): Powell confirmed he is intending to stay until his term finish, and that FED independence is very well understood and supported on both Washington and Congress. So, in the current FTC case, he admist he doesn’t really know the end results, but doesn’t think it will apply to the FED.
No intention whatsoever, never did, the press runs away with things.
Would like to see him more active on his idea to lower interest rates, is a good timing to lower them. Is he doesn’t, is not the end, but is a good timing, it should have taken place earlier.
What is the general opinion of economists regarding the trajectory of rate cuts? Do they think the fed should start cutting? What’s your opinion? Because if the general opinion is that it’s high time the fed cuts rates, then it may not matter if he appoints someone who will champion for rate cuts?
Trump considers naming fed chair early, signaling rate cuts could come earlier than expected
President Trump may name Powell’s successor earlier than expected, the Wall Street Journal reported citing people familiar with the matter.
Trump is considering naming Powell’s successor by September or October.
People being touted to succeed Powell include former Fed governor Kevin Warsh, National Economic Council director Kevin Hassett, Treasury Secretary Scott Bessent, former World Bank President David Malpass and Fed governor Christopher Waller.
Announcing the new fed chair in September or October would deviate from traditional three-month transition period and could give the new fed chair power to influence monetary decisions.
“I know within three or four people who all I’m going to pick,” Trump said during a press conference at the NATO summit. “He goes out pretty soon, fortunately, because I think he’s terrible.”
Bloomberg’s dollar gauge fell 0.4% to the lowest since April 2022 following the report.
https://www.wsj.com/economy/central-banking/trump-next-federal-reserve-chair-powell-d3edcb9c
