The Outlook: Contemplating the Path to Fiscal Hell
For the record, this contemplative piece has nothing to do with today’s cross-asset market price action, as I started writing last night.
Discussion
It’s safe to say that the majority of financial market participants have become desensitized to the outlook for fiscal policy, myself included. We see the projections and immediately become alarmed, but then we look at the control central bank/fiscal authorities around the developed world have on rates and conclude that even if all is not well in the long-term, for now policymakers have everything buttoned up - so, party on.
But this weekend was a bit of an epiphany for me where the macro outlook beyond Election Day started to really come into view. (What this outlook means for financial markets is a story for another day.)
Policymaker Complacency
On a $ for $ basis, a fiscal deficit adds to private sector net worth. It’s direct stimulus, no ifs, ands, or buts. Whether the recipient of said stimulus turns around and spends the $ back into the economy or uses the $ to pay down debt, that extra $ of direct stimulus provides instantaneous demand capacity (paying down debt simply frees up the rest of one’s balance sheet and earnings for spending that otherwise would have been used to service debt).
FED reporter Nick Timiraos had the following to say this weekend regarding fiscal policy’s current impact on the economy (recent FED commentary, specifically Waller, corroborates Timiraos’ comments, so this is not his independent opinion):
Clearly, the Fed is not concerned about the impact of sustained 5-10% of GDP fiscal deficits on sustaining 2% inflation over time. Given the history of elevated deficit spending, market participants can be forgiven for concluding the Fed is “gaslighting” the market and may be unofficially backing away from its 2% target. But, while I do not for a second agree with the Fed’s current approach to policy1, I think the shift toward a cutting cycle is actually logical given how rapidly YoY PCE inflation has fallen.
But this is dangerous policy complacency that cannot be rectified with a simple “opportunistic disinflation” approach to policy where the Fed simply holds indefinitely at the current Fed Funds rate in an attempt to grind inflation out of the economy without inducing a recession. When former FED Chair Greenspan implemented opportunistic disinflation, the fiscal deficit was steadily contracting, keeping a firm lid on nominal GDP growth. Today, not so much…
Fiscal Hell
Today, the fiscal deficit is over 5% of GDP and projected to run consistently above the worst levels of the 1960s to 1980s stagflation period. I’ve stared at this chart for months now, and for whatever reason it wasn’t until this weekend that this fact hit me over the head. There’s no other way to label what’s ahead than “fiscal hell”.
Right now YoY nominal GDP is sitting at 5.9%, right in line with the goldilocks period of the “opportunistic disinflation” Greenspan era of the mid-1990s. Combined with the fact PCE inflation is quickly disinflating and comfortably below 3% on a YoY basis, as discussed above, it’s no wonder policymakers are so complacent: on paper this is macro nirvana.
But without aggressive policymaker action, what’s ahead is fiscal hell2.
Trump the Deficit Hawk?
Joseph Wang provided an excellent overview this weekend in his weekly market update of what fiscal hell looks like, courtesy of Revolutionary France.
Given the outlook for the deficit, as we head into 2025 we need to be prepared for the US economy to come uncomfortably close to the brink of a Revolutionary France scenario. Even if President Biden is reelected I think both sides of the aisle would come together to avoid such an outcome via some form of deficit reduction, but the primary bulwark against a Revolutionary France scenario would likely have to be the Fed. However, what I’m most interested in contemplating right now is the prospect of a fiscally hawkish President Trump.
Rightfully so, due to his insane personality Trump’s policies are rarely taken seriously ahead of time. As such, the prospect of a fiscally hawkish Trump is laughable at best given Trump’s overt love of debt, but I think former Treasury policy advisor Stephen Miran is on to something:
Miran doesn’t say this specifically, but more than debt Trump loves being the hero. He is a “Tik Tok” policymaker with a laser focus on attacking the issues of the day. If you recall, during the 2015-2016 campaign Trump would hold a press conference almost daily, and he would routinely call out news items from the last 24-hour cycle and explain how he would deal with them as POTUS.
If the US comes to the brink of a Revolutionary France scenario, it is ENTIRELY plausible that Trump would attack that issue with aggressively hawkish fiscal policy and blame the economic/market fallout on the fact he needs to clean up the mess of his predecessor (yes, I understand the irony in that given his TCJA-led widening of the deficit and subsequent fiscal blowout in response to COVID).
This is a purely contemplative outlook piece, so no financial markets conclusions at the moment. But as we get closer to Election Day and Yellen/Brainard run out of TGA/RRP funds to contain the long end of the UST curve, the market implications of the US coming up to the brink of a Revolutionary France scenario will begin to come into view.
It just so happens that TODAY’s cross-asset market price action is a bit of a glimpse into what’s to come.
Since this inflation episode really gained traction toward the middle of 2022, I’ve been laser focused on the need for the Fed to create enough slack of the economy to ensure that inflation is durably back to target, such that when the economy inevitably rebounds out of this tightening cycle inflation does not shoot back above 2.5-3%. According to this framework, going for a soft landing is endlessly self-defeating, as we are witnessing in real time.
For a great discussion about the populism-driven stagflation period ahead, please refer to the discussion I had in February with Cem Karsan.