The Specter of Fiscal Dominance
On September 18th, Jay Powell and the Fed initiated a new policy easing cycle with a jumbo 50-basis point rate cut. The outsized cut was unprecedented. It came despite the highest and stickiest inflation at the start of an easing cycle in four decades. The jumbo cut also came despite the fact that the Taylor rule estimate of the neutral policy rate would have called for a 25-basis point hike.
Current market consensus overwhelmingly accepts the idea that the Fed is cutting rates to avoid any unwanted weakening in the labor market, and because inflation is thought to be on the “last mile” of its supposed one-way trip back down to the Fed’s 2% target. Now, the Western investors’ confidence in a continuation of the recent disinflation trend isn’t too surprising. After all, debt is fundamentally deflationary, and the U.S. has amassed a $35 trillion mountain of IOUs, with further trillions in annual deficits projected as far as the eye can see.
This week, however, three different Fed officials made comments suggesting that more Federal debt is no longer deflationary. Instead, it’s now inflationary. On Monday, Fed Governor Christopher Waller said, “For me, the biggest risk to r-star [the neutral rate] down the road is unsustainable fiscal policy.” On the same day, Minneapolis Fed-head Neel Kashkari told Bloomberg that “if U.S. debt continues to climb, the neutral rate will climb.” Then on Tuesday, San Francisco Fed president Mary Daly told Bloomberg that it’s “likely the neutral rate is higher than it once was.”
The neutral rate is the interest rate level that is neither stimulative nor restrictive for the economy. The indirect implication of a new reality in which higher debt equals a higher neutral rate is that higher debt now equals higher inflation. Simply put, a new positive correlation between higher debt and higher inflation would turn the consensus conventional wisdom on its head. So, what’s going on?
That more Federal debt is deflationary is indeed typically true, but that rule breaks down once a nation is in a condition of “fiscal dominance.” Fiscal dominance occurs as a country’s fiscal policy dominates monetary policy once debt and deficits get so large that the central bank can’t use traditional monetary policy to effectively control inflation. After decades of unsustainable fiscal policy that’s grown the debt by 44 times since 1981 despite tax revenue increasing by only 4.9 times over the same period, we now appear to have entered an era of U.S. fiscal dominance.
In short, the Fed’s inflation-fighting higher-for-longer interest rate policy of recent years has resulted in interest expenses that are greater than defense spending for the first time ever and growing faster than any other major government line item. If interest rates remain higher for longer, the unprecedented deficits will threaten a debt doom-loop that could ultimately trigger a sovereign debt crisis.
In eloquent Fed-speak, this week, Kashkari, Waller, and Daly essentially admitted that the U.S. Federal debt levels now require sustained negative real rates. Their comments offer initial evidence that the Fed knows monetary policy is caught in the vice of fiscal dominance, and provide strong support for the non-consensus view that the Fed is actually cutting rates aggressively to ease government financing stress—despite the potential implications of higher inflation.
If market consensus now begins to shift toward a widespread understanding of just how compromised the Fed has become, and by extension a widespread understanding of the inflationary ramifications, the precious metals bull market is likely to shift into an even higher gear.
According to analysis on the impacts of past rate cut cycles on precious metals prices, Bloomberg’s Ven Ram concluded that gold bullion has the potential to reach $3,229/oz and silver has the potential to exceed $37/oz “if slowing inflation in the US and a cooling labor market allow the Fed to reduce its benchmark rates by as much as the markets have priced in.”
What very few are apparently even considering, however, is the price potential for gold and silver if, as HAI suspects, the Fed continues to cut rates aggressively not because slowing inflation “allows” it but because the U.S. fiscal debt and deficit problem demands it, despite inflation.
Perhaps comments from TS Lombard economist Steve Blitz this week suggest that the transition to a new consensus view is just now getting underway. As Blitz said, “There is a bubbling sense that the absolute conviction of inflation returning to 2% might be more faith than fact.” As the Western investor wakes up to the new reality of U.S. fiscal dominance, HAI suspects a recognition moment in the collective mind of the market will trigger a mad Western scramble for gold and silver likely to dramatically amplify the present drivers of the precious metals bull and supercharge the price rally far beyond Ven Ram’s conventional calculations.
As the ratio of gold vs. long-term Treasurys attests, gold has outperformed long-term U.S. Treasurys by a staggering 12% compound annual growth rate for a decade on extremely low volatility and without any significant drawdowns. Despite this fact, Western capital remains fully locked into the traditional 60/40 portfolio, almost entirely unallocated to gold. With the specter of fiscal dominance now looming, however, HAI suspects we may not have to wait long now for that to change.
Weekly performance: The S&P 500 was up 0.85%. Gold was up 2.01%, silver was up by 4.66%. Platinum was up 3.03%, and palladium gained 1.41%. The HUI gold miners index jumped 7.94%. The IFRA iShares US Infrastructure ETF was up 1.92%. Energy commodities were volatile and mixed on the week. WTI crude oil was down 9.09%, while natural gas lost 14.21%. The CRB Commodity Index was off 3.93%. Copper lost 2.43%. The Dow Jones US Specialty Real Estate Investment Trust Index gained 2.92%. The Vanguard Utilities ETF was up 3.28%. The dollar index was up 0.61% to close the week at 103.31. The yield on the 10-yr U.S. Treasury was down 2 bps to close at 4.08%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
