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Large new deficits will alarm the Fed and precipitate tightening

Summary:
I want to go back to something I wrote 5 years ago about deficit spending because it’s very relevant today given the climate in Washington. And unlike most political decisions, I think this will be a key issue driving markets. Here’s the issue: The spending deal reached by congressional leaders Wednesday marks an end to the budget austerity congressional Republicans sought to advance in Washington in 2011. Back then, Republicans negotiated a series of automatic curbs on defense and domestic discretionary spending with President Barack Obama that, along with a growing economy and ultralow interest rates, helped bring down deficits. Now, party leaders have made a U-turn. Last December, President Donald Trump signed into law tax cuts of .5 trillion over a decade, and

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I want to go back to something I wrote 5 years ago about deficit spending because it’s very relevant today given the climate in Washington. And unlike most political decisions, I think this will be a key issue driving markets. Here’s the issue:

The spending deal reached by congressional leaders Wednesday marks an end to the budget austerity congressional Republicans sought to advance in Washington in 2011.

Back then, Republicans negotiated a series of automatic curbs on defense and domestic discretionary spending with President Barack Obama that, along with a growing economy and ultralow interest rates, helped bring down deficits.

Now, party leaders have made a U-turn. Last December, President Donald Trump signed into law tax cuts of $1.5 trillion over a decade, and congressional leaders Wednesday agreed with Democrats to boost federal spending by nearly $300 billion over two years from what was already in train.

Large new deficits will alarm the Fed and precipitate tightening

“This is the end of spending restraint as we have known it,” said William Hoagland, a former budget adviser to Senate Republicans now at the Bipartisan Policy Center in Washington.

The tax cuts and new spending should boost economic growth this year and next. Gross domestic product could rise to around 2.7% this year, compared with 2% without the policy changes, with the boost equally split from the tax cuts and the spending deal, according to projections by research firm Evercore ISI.

The Fed will definitely offset this. What we’re seeing here is a textbook example of how monetary offset works. The worrying thing is that, while we might have wanted larger deficits earlier in the business cycle, in 2009-2013 for example, this increase in spending is more contentious.

Two things: first, for the Republicans, this is purely political. They want to have a juiced-up economy for the 2018 Midterm elections to ensure the best possible outcome for their party. Since they control the Presidency, the House and the Senate, the Republican party will disproportionately receive credit or blame for the economy.

Second, this is not necessarily NPV positive spending for the economy. A lot of it is military spending. And while that can add some money to the private sector through defense contractors and the military-industrial complex, this kind of spending does nothing for longer-term growth.

The question is: will this be inflationary?

That’s where my post from 2013 comes in. It’s about how bond market vigilantes force rates higher. Here’s the basic framing:

The implicit understanding is that inflation spirals out of control and the bond vigilantes front run the central bank’s move to counteract this inflation….

The question, therefore, is whether inflation can ever rise enough to force the central bank into action. And any increase in longer-term yields is an implicit indication that bond market participants believe it could.

The question is the one Paul Krugman asked in 2013:

Suppose, now, that we were to find ourselves back in that situation with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.

So then what? The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So?

[…]

…once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation.

My response was incredulity:

Of course running enormous deficits when the economy is operating at full capacity causes inflation to go haywire. Of course it does.

But again, why would the government have a large net deficit position if the private sector is not deleveraging and running up its net saving position? This could only happen if our politicians went mad and added yet more fiscal stimulus to the economy even after it was overheating.

This is exactly where we are, isn’t it? Kudos to Paul Krugman for recognizing the madness of politicians!

Now, arguably, inflation’s not a threat here if you believe we are in an age of oversupply as Dan Alpert argues. That says we’re not at full capacity. Moreover, since the broadest measures of unemployment are still above 8%, we’re arguably also not at full employment. And yesterday I already recounted why wage gains don’t have to cause inflation. So the outcome here could be benign — more growth, lower unemployment, inflation rising modestly toward the 2% target.

Even so, given what we know about the Fed’s model, I think the Fed will be forced to react. A fourth rate hike for 2018 is back on the table then. And maybe a fifth if we see movement in inflation measures.

The bottom line here is that policy doesn’t occur in a vacuum. Back in November, I thought corporate tax cuts were enough to put a fourth rate hike on the table, with a fifth possible as a result of inflation rising. Now, with the Fed already on notice about inflation because of “low, low unemployment”, massive amounts of new deficit spending will only move up their timetable. And bond rates will rise as a result.

Edward Harrison
I am a former European credit markets and M&A guy who started out as a diplomat. — so I have some pretty diverse interests.

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