This article delves into the glaring divergence between U.S. fiscal policy and U.S. monetary policy over the past year, and its differential impact on various sectors of the economy.
It also takes a look at the sharp variance in these policies among the United States, Europe, and China.
The Clash of Titans: The Fed vs the Treasury
Over the past several years, navigating an overarching macroeconomic framework has been indispensable. Yet, maintaining agility and adaptability within that framework has been equally crucial. In retrospect, my success was attributed to my willingness to continuously revise my perspective based on the dynamic indicators during these tumultuous times.
From 2019 into 2022, I took a bullish stance on inflation and a bearish position on bonds, underscoring the likely manifestation of fiscal-driven inflation. I defined it as a shift from monetary dominance to fiscal dominance. This foresight turned out to be remarkably accurate as the market bore witness to a four-decade-high inflation and the most severe bond bear market in modern history. The timing and magnitude of these events closely aligned with my predictions.
Thus far, the tools employed by central banks have not been inflationary, primarily uplifting asset prices rather than bolstering middle-class consumption. They engaged in money printing, yet retained the money within central bank balance sheets by procuring bonds.
If central bank measures become more aggressive, coupled with fiscal policies and a focus on the middle class, they hold the potential to override the prevailing deflationary pressures with sheer monetary expansion. They can dispense helicopter money to alleviate debts, escalate inflation, bolster infrastructure, rescue underfunded pension systems, and fortify the middle class, should policymakers opt for this course.
I certainly wouldn’t want to possess a 20-year or a 30-year bond at remarkably low fixed yields in such an environment. Negative yields would be even more precarious.
– Excerpt from “The Bond Market is Spookier Than the Stock Market,” July 2019
Eventually, by early-to-mid 2022, it became apparent that the Fed intended to aggressively combat inflation, a stance that caught me off guard. Subsequently, my viewpoint shifted towards an impending cyclical period of disinflation and likely recession, while emphasizing my belief in more inflationary cycles throughout the decade. Historically, most inflationary periods comprise multiple discrete waves of inflation and disinflation, and this was shaping up to be no exception.
Initially, I anticipated the peak in year-over-year inflation to occur in Q1 2023, with some caveats concerning the right-tail risk from potential oil shortages that could extend it. The invasion of Ukraine by Russia in late February 2022 indeed activated this right-tail risk, contributing to the inflation peak a couple of months later in Q2 2023.
Due to base effects in the CPI calculation, there’s a reasonable likelihood of witnessing a local peak in the official CPI sometime in Q1 2022 within the 7-9% year-over-year range.
– Excerpt from Stock Waves Report, December 12, 2021
The producer price index is indicating signs of having reached a local peak in year-over-year terms. I anticipate a similar occurrence for the headline CPI by late Q1 or early Q2. Essentially, I believe there’s a good chance that year-over-year inflation will reach a local peak in a couple of months, leading to a period of stagnant or lower year-over-year inflation prints, while still remaining above the target. The right-tail risk to this view is that a spike in oil prices this summer due to supply shortages and strong demand from emerging markets could result in inflation, or more precisely, stagflation, even higher than my base case.
– Excerpt from Stock Waves Report, February 2, 2022
Overall, I continue to regard the macro environment as being in a cyclically disinflationary period, amidst an inflationary decade. Thus, managing a portfolio hinges on one’s time frame; assets anticipated to perform well over the next 5+ years could feasibly exhibit weakness over the next 6-12 months. When in doubt, I consistently adhere to my longer-run timeframe, while endeavoring to rebalance around the fringes, counter-cyclically.
– Excerpt from Stock Waves Report, August 7, 2022
Collectively, the consumer price index has surged by 19% since the start of 2020, which spans four years now. Under normal circumstances, with the Fed meeting their 2% inflation target annually, this increase would amount to approximately 8% during this period. This enduring elevation in prices elucidates why, despite cooling down in terms of rate of change, inflation still poses a burden for many individuals:
Back in May 2022, when interest rates loitered below 1%, I published an article, “Inflation Or Recession,” where I posited that the Fed’s tightening would likely yield a myriad of outcomes:
The Fed can plausibly persevere with tightening for an extended period. However, if the Fed raises rates to 3%, 4%, 5%, and beyond, when the debt as a percentage of GDP stands at such elevated levels, the annual interest expense of the U.S. Treasury would surpass $1 trillion, potentially precipitating financial distress among myriad companies and households attempting to refinance their debts. Moreover, a persistent reduction in their balance sheet through QT would exert a negative drag on money creation and asset prices.
