July 2, 2023
This newsletter issue elaborates on my recent article about the relationship between interest rates and consumer price inflation to explore the topic of fiscal dominance.
One of my big themes since 2020 was that the fiscal policy we are seeing this decade will be inflationary, and that unlike recent business cycles, interest rates may not be the best policy tool to deal with that inflation. And while that has been correct, the challenge has been navigating the specific path as we go through the various twists and turns of such an unusual macroeconomic environment.
A Turning Point
The year 2022 was tough for most investors. The Federal Reserve began rapidly tightening monetary policy, while the 2020/2021 stimulatory fiscal deficits also tightened significantly back to roughly 2019 levels as a percentage of GDP. While S&P 500 declines were moderate, bond prices fell rapidly along with stocks, and so it was one of the worst years in modern history for a combined 60/40 stock/bond portfolio.
Most economic indicators were decelerating too. The first half of 2022 saw two consecutive negative quarters of real GDP growth. The Conference Board leading economic index rapidly fell, the purchasing manager’s index rapidly fell, and the yield curve flattened and eventually inverted. As of this writing, the real GNI is currently negative on a year-over-year basis, which going back to 1948 has only occurred during recessions. Most forward indicators continue to suggest that recession is ahead.
By late Q3 2022, the U.S. Treasury market started to become rather illiquid, and the U.K. sovereign bond market outright broke and required intervention by the Bank of England.
But then some things began to change at the start of Q4 2022. The U.S. Treasury began dumping liquidity back into the market and offsetting the Fed’s quantitative tightening, and the dollar index declined. The S&P 500 found a bottom and began stabilizing. The liquidity in sovereign bond markets began easing. Various liquidity-driven assets like bitcoin turned back up.
And importantly, the U.S. fiscal deficit in absolute terms and as a percentage of GDP began to grow again. Running deficits equal to 8% of GDP while the unemployment is under 4% is very unusual.
Interest Rates vs Inflation
There are two main causes for higher-than-normal broad money supply growth, which tends to be inflationary for consumer prices when it happens.
The first cause is rapid bank lending, which tends to be tied to demographics. The 1970s were the main example of this type of inflation, which occurred as the initial members of the large baby boomer generation (born in the late 1940s and early 1950s) began entering their homebuying years (they began turning 25 throughout the 1970s), which meant a lot of credit formation.
The second cause is large monetized fiscal deficits, which tends to be tied to conflict. The 1910s (World War I), 1940s (World War II), and the 2020s (COVID-19) were examples of unusually large fiscal deficits and new money creation that was not tied to bank credit creation. In addition to instances of conflict, large fiscal deficits can also be tied to demographics as well, if for example a large generation enters their retirement years, which is now happening to the baby boomer generation.
This chart shows the sources of money creation over time:
We can zoom in on certain periods to make this more clear. The 1970s period had year-over-year bank loan creation that was larger in absolute dollar terms than year-over-year federal debt increases. In other words, bank lending was in the driver’s seat:
In contrast, for the recent period, year-over-year federal debt increases are larger than year-over-year bank loan creation. Fiscal deficits are in the driver’s seat:
During the 1940s, interest rates were not used as a policy tool to fight inflation, because it was fiscal-driven inflation rather than lending-driven inflation. Instead, the primary policy tools focused on ending the war, ceasing the fiscal deficits, and pivoting back towards a period of financial austerity.
During the 1970s, raising interest rates and performing other actions to reduce the high rate of bank lending was a successful inflation-fighting strategy, because it tackled the problem head on. Other non-monetary policies included improving the supply-side, such as resolving or getting around geopolitical oil embargoes. Federal debt as a percentage of GDP was only 30%, so higher rates on the public debt were manageable compared to the reduced rate of loan creation in the private sector that higher rates led to.
During the 2020s, we have a different problem. Most of the inflation was caused by large 1940s-style fiscal deficits, and yet the Federal Reserve has primarily used a 1970s-style playbook of raising interest rates to deal with it, even though that’s primarily a tool to constrain lending. However, raising interest rates when federal debt is over 100% of GDP substantially increases those deficits at an equal or larger pace than it reduces loan creation in the private sector.
An issue here is that the Federal Reserve doesn’t really know what else to do, because their tools don’t really address deficit-driven inflation; their tools are meant to deal with lending-driven inflation. It’s a fiscal matter, and so the best the Federal Reserve can do is try to suppress the private sector to offset some of what’s happening in the public sector, even though that’s not addressing the core problem.
So as the Federal Reserve raises rates, federal interest expense increases, and the federal deficit widens ironically at a time when deficits were the primary cause of inflation in the first place. It risks being akin to trying to put out a kitchen grease fire with water, which makes intuitive sense but doesn’t work as expected.
The effective federal interest rate increases with a lag, since it consists of many different durations. Their short-term debt gets refinanced to higher rates within a few months or years, while their longer-term debt remains locked in until it matures and needs to be refinanced at the new higher rates. If all of the federal debt was yielding what T-bills currently yield, the annual interest expense would already be over $1.6 trillion, and the total fiscal deficit would be about 10% of GDP.
To quantify it another way, every 1% increase in the weighted average interest rate of the $32 trillion federal debt results in $320 billion worth of additional annual interest expense. That’s equivalent to the government hiring 2 million people at $160,000 per worker per year. Or, it’s equivalent to adding ten NASA’s worth of annual expenditure.
Even if we trim the $320 billion number in our analysis to account for the portion of debt held currently by the Social Security Fund and so forth, the portion that flows out into the economy is still extremely large. Plus, over the next 12 years, the $2.9 trillion Social Security fund that was built up over the past several decades is going to be emptied into the economy, as more and more seniors draw from it relative to the number of workers contributing to it.
Different Propensities to Spend
The hard part of this analysis is trying to map out and weigh the forces that are pushing against each other.
Tighter monetary policy does put downward disinflationary pressure on parts of the private sector, and we’ve been seeing that over the past year. Real estate and unprofitable tech companies in general are having a rough time with higher rates, which puts downward pressure on asset prices and consumer spending. That is offset by the greater income that certain entities are getting from higher fiscal deficits (including both the baseline deficits as well as the higher federal interest expense). So, the question becomes: how impactful are each of those forces?
If the government gives everyone $10,000 and they rapidly spend it, it’ll be inflationary for most prices, because there will be a lot of money chasing a finite amount of goods and services. On the other hand, if the government gives everyone $10,000 and for some reason nobody spends it, then prices won’t change much.
Here’s another way to conceptualize it. If the government gives $10 billion each to the top 100 richest billionaires in the country (a total of $1 trillion), it’s unlikely to be inflationary for the price of most consumer goods. Those 100 people already spend on personal consumption as much as they want to; any additional money they get will generally go towards saving and investing in financial assets, with maybe a bit towards some ultra high-end luxury goods (e.g. we might see some inflation in Manhattan penthouses and the prices of super-yachts). On the other hand, if the government gives $5,000 each to two hundred million people in the bottom two-thirds of the income spectrum (which is also a total of $1 trillion), then they’re likely to spend it on rent, food, fuel, cars, and so forth, which is likely to inflate the prices of those things. Those people have a greater propensity to spend any stimulus they receive, because their income and expenses are roughly the same and thus their income is the strict limiter on their spending capacity.
What these extreme examples illustrate is that when determining how inflationary a certain amount of fiscal deficit spending is, we have to consider what percentage of it is likely to get 1) spent on consumer goods vs 2) saved/invested in capital goods vs 3) spent on luxury goods. Does it go towards younger and less affluent people or does it go towards older and more affluent people? It’s not all equally inflationary, or more specifically, it’s not equally inflationary for the same set of things.
In the current case, raising government interest expense by $1 trillion in total mainly sends that money towards the wealthier end of the spectrum, but not in as extreme a way as the first example with the billionaires. These larger deficits from higher interest expense flow toward large bond funds, toward insurance companies, toward banks, toward cash-rich corporations, toward large endowments, and toward international creditors (and overall, about three quarters of Treasuries are held domestically and about a quarter are held internationally). It also goes toward middle class and upper-middle class retirees though, who have a propensity to spend on travel, restaurants, healthcare, real estate, and various things. The wealthier ones can also help their kids and grandkids with home purchases, weddings, and other large events, and thus spend the money into the economy through that channel. So, the propensity to spend bond interest is lower than the propensity to spend stimulus checks or child tax credits, but is not insignificant.
Interest Rate Sensitivity
When judging how impactful interest rate increases will be at curtailing private sector activity, a big variable to consider is whether the country relies on fixed-rate or variable-rate debt for its housing sector.
The United States has among the highest ratios of fixed-rate mortgages in the world:
To the extent that Australia raises interest rates and keeps them elevated, it starts putting serious pressure on household finances as their monthly variable-rate housing payments rise. But in the United States, over 90% of mortgages are fixed-rate. Households have locked in most of their mortgages at under 4% for the next few decades.
So, when the U.S. Federal Reserve sharply raises rates, it mainly hurts regional banks, commercial real estate, small businesses that rely on bank loans, junk-rated companies that rely on relatively short duration bonds, unprofitable tech stocks, and anybody who wants to buy a house or move and exchange houses. Among those, the interest rate pressure on small businesses is likely the most suppressant for the economy. The higher interest rates also negatively affect people or businesses whose income relies on housing turnover, because that’s down (since people with fixed-rate mortgages never want to sell their home now, if they can help it). It doesn’t significantly affect most U.S. homeowners with existing mortgages, nor does it significantly affect large and profitable blue-chip stocks that also have existing long-duration low-rate debt.
On the other hand, the U.S. economy is more financialized with regards to its stock market than most other countries. Executive compensation is heavily tied to equity performance, and so by extension, income tax receipts are heavily tied to equity performance. So, to the extent that higher interest rates put pressure on stock prices, it also puts pressure on U.S. tax revenue, which means larger fiscal deficits. Intentional or not, we basically have automatic public sector inflationary stabilizers in place to offset various sources of private sector disinflation that can occur.
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.
During much of 2022, the downward pressure on the private sector from tighter monetary policy was winning. It squeezed quite a number of asset prices and slowed everything down to stall speed. In particular, the fact that the Federal Reserve was and still is doing quantitative tightening (reducing its balance sheet) has been adding some extra oomph to its interest rate increases.
However, 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.
The result thus far has been sticky inflation and delayed recession. The inflation has taken longer to get down than many people thought, but also, the potential for recession keeps being pushed out quarter by quarter longer than many people thought, due to the ongoing stimulatory effects of large deficits that are pushing against the recessionary effects on certain parts of the private sector.
As we look years into the future via the following chart from the Congressional Budget Office, the rising federal debts and deficits will cause the fiscal dominance to continue to increase, which means interest rates become a less and less useful inflation-fighting tool over time.
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And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
- Replaced TXN with V.
I use small allocations to bitcoin price proxies such as MSTR and GBTC in some of my portfolios for lack of the ability to directly buy bitcoin in a brokerage environment, but compared to those types of securities, the real thing is ideal.
I recommend holding actual bitcoin for those that want exposure to it, and learning how to self-custody it. I buy mine through Swan.com.
I don’t have a firm view on the bitcoin price over the next six months, but I am bullish with a 2-year view and beyond.
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Final Thoughts: The Japan Comparison
Many analysts assume that as Europe and the United States continue to age and shift towards fiscal dominance over time, they will begin to resemble Japan in terms of disinflationary stagnation.
Some of that is right, but in my view there are several key differences that we need to be aware of.
-Japan aged ahead of everyone else, which was during the 1990s-2010s period of rapid globalization. China ramped up its production and supplied the world (including Japan) with inexpensive goods and helped overcome the potential for labor shortages.
-Japan has the largest net international investment position in the world, and usually has a current account surplus. More income flows into the country each year than flows out.
-Japan spends less than half of what the United States does on healthcare per capita, despite having a median age that is 10 years older. When the United States is the same average age as Japan, we may have 3x the per capita healthcare cost as Japan. This is a huge difference as the United States ages.
-The United States spends 3-4% of its GDP on its military, while Japan spends about 1% of its GDP on its military. And now geopolitical conflicts are heating up compared to the 1990s-2010s unipolar period.
Through the Looking Glass
When Alice went through the mirror in the famous book Through the Looking Glass, everything was flipped and different.
That’s a useful analogy for describing the relationship between fiscal dominance and interest rates.
-When sovereign debt is low and most money creation comes from bank lending, higher interest rates do exactly what we expect them to do: slow down loan creation and inflation. Alice is in the real world.
-When sovereign debt is high and as much money creation comes from fiscal deficits as it does from bank lending, then it becomes a tug-of-war. Higher interest rates have mixed effects, as they do suppress the private sector lending but also increase the deficit by a similar degree. Alice is on the precipice of the mirror, but not yet through it.
-When sovereign debt is extraordinarily high and far more money creation comes from fiscal deficits than from bank lending, higher interest rates can become outright positively correlated with inflation. Alice has gone through the looking glass, and everything is flipped.
The United States is approximately in the second category. We’re on the precipice. Annual fiscal deficits already exceed annual loan creation in dollar size, but due to the muted propensity to spend interest income, the two forces seem to be roughly tied, and possibly still leaning towards loan creation having more weight. We’ll find out with more detail in the coming quarters.
Japan is the main example of a country that is already through the looking glass, where everything is flipped. Their deficits greatly exceed their loan creation. They’re already at the point where interest rates aren’t an effective inflation-fighting tool, which is likely part of the reason they’ve been doing the heterodox policy of not using interest rates in the face of inflationary pressures. With public debt equal to about 250% of GDP, every 1% higher weighted average interest rate on Japanese debt would increase the fiscal deficit by about 2.5% of GDP. To the extent that Japan sees above-target consumer price inflation in the years ahead, it likely won’t be due to excessive bank lending, but rather will be from high energy or materials import costs, and so that requires more of a fiscal/geopolitical toolset than a monetary one.