This piece delves into the significant divergence between U.S. fiscal policy and U.S. monetary policy in the recent past, dissecting its distinct impacts on various sectors of the economy.
It also explores the notable divergence between the U.S., Europe, and China on these critical policies.
The Federal Reserve Versus the Treasury Department
Over the past several years, having a comprehensive macroeconomic framework has been crucial, but the ability to adjust and adapt within that framework has been equally vital. Some calls were spot on, some were far from it, but the key was being open to continuously revising the outlook based on evolving indicators in these tumultuous times.
From 2019 to 2022, I was bullish on inflation and bearish on bonds, especially emphasizing the potential emergence of fiscal-driven inflation. I delineated the shift from monetary supremacy to fiscal dominance. This forecast was right on the money. I outlined the scenario and its likelihood before it unfolded, and as inflation soared to levels not seen in four decades and triggered the worst bond bear market in modern history, I could closely track its timing and magnitude.
Up to now, central bank tools have primarily buoyed asset prices rather than the consumption of the middle class. By purchasing bonds, they injected money into the system but retained it on their balance sheets.
If central bank actions become more aggressive, converge with fiscal policies, and begin to focus on the middle class, they possess the potential to override various disinflationary pressures through sheer monetary expansion. They could issue helicopter money to alleviate debts, spur inflation, foster infrastructure development, rescue underfunded pension plans, and support the middle class, if policymakers opt for such measures.
The prospect of holding a 20-year or 30-year bond at exceptionally low fixed yields in such an environment doesn’t seem appealing. Negative yields would be even more precarious.
– Excerpt from “The Bond Market is Spookier Than the Stock Market,” July 2019
When total debt is high, interest rates hit the zero bound, and measured inflation is quite low, monetary policy loses its firepower. At that juncture, currency devaluation and direct fiscal expenditure, which the monetary authority acquires by augmenting the monetary base rather than the fiscal spending being procured from real private lenders, becomes a more potent stimulus tool. Fiscal spending usurps monetary policy and leads it. The 1940s and, so far, the 2020s were characterized by fiscal policy dominance in the United States.
– Extract from “A Century of Fiscal and Monetary Policy,” September 2020
Rapid expansions in the broad money supply that escalate demand for goods and services without a corresponding surge in the supply of goods and services trigger supply shocks and spur price inflation. With time, this price inflation becomes transitory in terms of rate of change, yet the prices ultimately stabilize at a higher level due to a permanent infusion of money into the system. This latter form of inflation is likely what we are witnessing at present.
– Segment from “Fiscal-Driven Inflation,” May 2021
However, by early-to-mid 2022, it became evident that the Fed was intent on staunchly combatting inflation, more so than I had anticipated. My perspective then shifted towards a cyclical phase of disinflation and a probable recession from that point, while reiterating the likelihood of multiple inflationary cycles in the overarching decade. Throughout history, most inflationary periods have comprised distinct waves of inflation and disinflation, and this time was shaping up to be no exception.
I initially anticipated that the peak in year-over-year inflation would occur in Q1 2023, with caveats regarding the right-tail risk stemming from potential oil shortages that could prolong this period. Russia’s invasion of Ukraine in late February 2022 indeed activated that very right-tail risk, thereby contributing to a peak in inflation a couple of months later in Q2 2023.
Due to baseline effects in the CPI calculation, there is a fair chance of observing a local apex in the official CPI sometime in Q1 2022 within the 7-9% year-over-year bracket.
– Excerpt from Stock Waves Report, December 12, 2021
The producer price index is indicating signs of hitting a high point in year-over-year terms. I believe we will likely see a similar trend for headline CPI by late Q1 or early Q2. I think there’s a good chance that year-over-year inflation will reach a local peak in a couple of months, and we will witness a phase of stagnant or lower year-over-year inflation figures for a while, albeit remaining above the target. The right-tail risk to this outlook is that if oil prices surge in the summer due to supply shortages and robust demand from emerging markets, it could result in higher-than-envisioned inflation (or more precisely, stagflation).
– Excerpt from Stock Waves Report, February 2, 2022
Overall, I continue to view the macro environment as being in a cyclically disinflationary period amidst an inflationary decade. Managing a portfolio hinges on one’s timeframe; assets expected to perform well over the next 5+ years could be weak over the next 6-12 months. When in doubt, I always adhere to my longer-run timeframe, although I strive to rebalance around the fringes counter-cyclically.
– Excerpt from Stock Waves Report, August 7, 2022
Aggregate consumer prices have surged by 19% since the start of 2020, which equates to four years ago. Under normal circumstances, where the Fed achieves its 2% annual inflation objective, the increase would have been around 8%. This sustained elevation in price levels is the reason why, despite a cooling down in inflation rate, many people still perceive the current inflation as lofty.
Back in May 2022, when interest rates were still below 1%, my article at that time was titled “Inflation Or Recession,” in which I presented a viewpoint that the Fed’s tightening would likely yield numerous outcomes:
The Fed can plausibly continue its tightening for a prolonged duration. However, if the Fed raises rates to 3%, 4%, 5%, and beyond when debt as a percentage of GDP is this high, the annual interest expense of the U.S. Treasury would surpass $1 trillion, precipitating challenges for many companies and households in refinancing their debts. Moreover, by persistently shrinking their balance sheet with QT, it will yield a negative impact on money creation and asset prices.
