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Fiscal Dominance Part 1

Posted:January 20, 2024

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Paul Hancock, CFP®    January 20, 2024

2023 turned out to be a resilient year for the U.S. economy. Many economists and strategists came into the year predicting a recession which turned out to be a bad call. In my article from February of 2023, I noted the following:

“The Federal Reserve has an incredibly large uphill battle in the coming years. The question remains can the Fed tame the level of inflation by raising interest rates to a level that does not tank the economy and cause further instability in financial markets?”

Let’s review the outcome of these components for the past two years:

Inflation - Price inflation as measured by the CPI dropped from 7% at year-end 2021 to 3.4% at year-end 2023. A lower level of inflation has been positive for the economy.

Interest Rates - The Federal Reserve target rate increased from 0.25% in 2021 to 5.5% at year-end 2023.

Economic Growth (GDP) - Gross Domestic Product (GDP) expanded at 4.9% at the end of Q3 of 2023 slightly lower than at the end of Q4 of 2021 at 5.9%. Growth has remained strong.

Financial Market Instability - Certainly, the insolvency of Silicon Valley Bank in March of 2023 was a moment of instability. But Central Bankers will do what Central Bankers do. The Fed created the Bank Term Funding Program (BTFP) to provide liquidity to banks. I won’t go into all the details, but essentially they re-liquified the balance sheet of many banks to stem deposit outflow. 

I am not a fan of Central Bankers, but the Fed has done a pretty darn good job over the past two years. The Fed raised interest rates at the fastest clip since the early 1980s and the economy kept humming along. What gives?

 

Monetary & Fiscal Policy Actions

Since the United States officially left the gold standard in 1971, most fiat currencies have floated freely against one another with no backing of gold or hard money. Policymakers have attempted to manage economic growth and markets via Monetary Policy and Fiscal Policy. 

Monetary policy refers to actions taken by a country’s Central Bank to manage economic growth by lowering and raising interest rates, contracting or expanding its balance sheet, and influencing the number of bank reserves and base money in the system.

Fiscal policy refers to the use of government spending and taxation to influence the economy.

Since 1971, the U.S. has relied heavily on monetary policy by lowering interest rates to stem slumps in economic growth. This mostly started in 1982 and continued into the 2010s when the U.S. hit 0% after the Global Financial Crisis. However, each time rates were lowered, the effect on economic growth diminished. In other words, once rates hit the “zero-bound,” they needed other tools. 

 

Figure 1: Fed Funds Rate & 2-Year U.S. Treasury Rate

Source: DoubleLine

 

Everything changed in 2020 when fiscal authorities ramped up fiscal stimulus. The government has been consistently running a budget deficit, spending more than it earns in tax receipts, since 1971 as seen in Figure 2 below. We’ve barely managed a surplus once in the past 50 years in the late 1990s as seen in the green shaded area of the chart. The deficit ballooned after the Global Financial Crisis and then went parabolic in response to the COVID-19 pandemic. It was then that authorities finally remembered the impact of fiscal stimulus, especially when monetary policy and fiscal policy actions coordinate with one another. Years and years of consistent budget deficits have resulted in the total national debt surpassing $34 trillion in early 2024. The total interest outlays on U.S. federal debt are now close to $1 trillion per year. Interest alone is running at 15% of all tax receipts (federal revenue).

Figure 2: Budget Balance (Inverted) and Unemployment Rate

Source: DoubleLine

 

Fiscal Dominance

Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that "dominate" central bank intentions to keep inflation low. (St. Louis Fed Economic Research).

In response to COVID-19, the Federal Reserve in lock-step with Congress and the President massively expanded its balance sheet and increased the monetary base. In other words, they printed fresh dollars and pumped them into the economy that was frozen due to the lockdowns. This had a massive effect on the broad money supply which grew by 40% from 2020 to 2022. While our economy was saved from the abyss, the side effect was higher levels of inflation as a result of a rise in the money supply. This is the push and the pull factor. The Fed has a mandate to keep price inflation steady at a 2% annualized rate. Even after a dramatic increase in interest rates in the past couple of years, inflation has remained elevated. Thus, the “fiscal dominance” has offset rising rates and kept stimulating the economy with ever-increasing budget deficits and rising federal debt. 

Side Effects: Inflation & Rising Interest Rates

I think it’s important to stop and specifically define “inflation”. My view of inflation is very simple. “inflation is an abnormal increase in the volume of money and credit resulting in a substantial and continuing rise in the general price level” The Merriam-Webster Dictionary.

Therefore, inflation is simply when the Government creates too much money and credit. Inflation is not rising prices. Rising prices are the result of inflation. 

“the state alone is responsible for inflation: inflation without government, or indeed against government, is impossible.” Felix Somary

Longer-term interest rates have seen a steady drop over the past 40+ years as a result of easier and easier monetary policy. This stimulative policy aided financial markets causing bull markets in stocks, bonds, and real estate in the U.S. In my opinion, this secular drop in interest rates ended in 2020 (see Figure 3). Therefore, I expect over the next 5-10 years inflation and interest rates will remain elevated. This will not be a smooth ride upward in terms of rates. As seen below, while rates dropped from 1989 to 2024, there were many ups and downs along the way. I believe we’ll see a similar chart on the path upward.

 

Figure 3: U.S. Rates: 30-year U.S. Treasury Yield

Source: DoubleLine

 

Portfolio Implications

If my base case is higher levels of monetary inflation and higher interest rates, what does that mean for markets? 

Large fiscal deficits and stimulus are broadly positive for risk assets including stocks. The government deficit is the private sector's credit after all! All this money printing and stimulus has to go somewhere. Large-cap global companies have seen a lion’s share of this stimulus resulting in record profits. I don’t see this changing anytime soon. While valuations in the United States remain elevated, I’m broadly positive about global stock markets in general for the foreseeable future. Any pullback in stock markets presents investors with a great chance to buy low. Higher levels of monetary inflation should also support inflation-hedge assets such as gold, commodities, and real estate.

Higher and rising interest rates broadly speaking should impact the bond markets negatively. This doesn’t mean investors should shun bonds, but rather, be active in their management of bonds in a portfolio. I like mostly short to intermediate-term individual high-quality bonds in this environment. To the extent investors can buy individual bonds and hold them until maturity, this should help shield investors as rates rise. This can be done outright and also with select managers who perform this function for investors.

In part two of this commentary, I plan to explore the history of monetary and fiscal policy from 1971 until today to attempt to explain where we are in that cycle and its implications for the future.

References

 

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