“Whether you think this is a situation of its own making or not, the US Federal Reserve has a difficult balancing act ahead of it. It wants to keep interest rates low to help the US Government manage its record debt-pile as easily as it can, but at the same time may need to hike borrowing costs to ensure inflation does not rear its ugly head after 40 years of lying dormant,” says AJ Bell investment director Russ Mould. “In addition, the American central bank wants to support the US economy but does not (or should not) want to let financial markets become bubbly and addicted to cheap liquidity as a financial market collapse could usher in a downturn or even a deflationary spiral, should margin debt, malinvestment and the loss of paper wealth combine to knock sentiment and spending power.
“Investors now have to assess which way they think the Fed (and the White House) will go and to what degree the central bank’s ultimate policy path is priced into bonds, equities, commodities and currencies. In the end, every option available to the chair Jay Powell and President Biden may help in some areas but do damage in others, as if to confirm the view of Stanford University professor Thomas Sowell that ‘There are no solutions, only trade-offs.’
“This may be why the Fed spends so much time jawboning, because its room for manoeuvre is limited. Several Fed officials have spoken in the wake of last week’s Federal Open Markets Committee (FOMC) meeting, which hinted at two, quarter-point rate hikes by the end of 2023, but the messages have been mixed.
“No sooner had the Fed talked of those two rate rises, than St Louis Fed President James Bullard publicly spoke of a possible increase in 2022, to nip inflation in the bud. Yet the next day Minneapolis Fed President Neel Kashkari made the case for leaving any rate increase until at least 2024.
“The Fed is at least sticking to its script that the current spike in inflation is transitory, although even here the cracks are appearing. Atlanta Fed President Raphael Bostic is now suggesting a rate rise may be appropriate for 2022 because inflation could go higher than thought for a little longer than expected, before it recedes, a view endorsed by Governor Michelle Bowman.
“But that would start to increase the interest bills paid by the US Government, potentially hitting economic growth in the process.
“During the first 200 years of its existence, the USA accumulated a cumulative federal debt of $1 trillion, the equivalent of 30% of its GDP. In the last 40 years, that figure has surged to $28 trillion.
“The good news is that the US economy has grown too, as annual GDP has advanced from around $3 trillion to $23 trillion.
“But America’s national debt-to-GDP ratio has still grown from roughly 30% to 128% over the same time period and that is bad news for two reasons:
• First, it means that it is taking ever-increasing amounts of debt to generate an extra dollar of GDP.
Source: FRED – St. Louis Federal Reserve database
• Second, it leaves the US sitting well above the 80% to 90% debt-to-GDP ratio described by economists Kenneth Rogoff and Carmen Reinhart as a key tipping point, whereby economic growth would slow thanks to (unproductive) debt servicing costs – although that research, used by many Governments as the basis for austere fiscal policies in the last decade, has since been widely challenged.
Source: FRED – St. Louis Federal Reserve database
“Whether investors agree with Rogoff and Reinhart or not, history is very clear that there are only four ways out once a national debt reaches America’s current levels, relative to GDP:
• Rapid economic growth. This is the best option, but it is not proving easy, if the period from 2009 and the end of the Great Financial Crisis is any guide. This underpins the push toward Modern Monetary Theory and the argument that Governments should spend on productive assets and focus on the long-term payback rather than worry about near-term borrowing.
• Default. This is not ideal, as serial offenders like Argentina will attest. It leaves you locked out of international debt markets and means you must pay higher coupons even if you can persuade someone to lend to you. It can also prompt capital flight, hitting both your currency and value of other assets and financial markets. The US will not countenance anything that jeopardises the dollar’s status as the world’s reserve currency (although most other developed countries face the same dilemmas and policy options).
• Inflate. This is more like it and is exactly what the US and UK did when debt ballooned thanks to World War Two. Rebuilding programmes and public spending fuelled growth, interest rates were kept below inflation and lenders were repaid in effectively devalued currency as a result. Yet again, though, this leaves the Fed with the dilemma of stoking some inflation but not too much that investors take fright and both financial markets and the wider economy are destabilised, as happened in the 1970s.
• War. This is the option that no-one in their right minds would consider, even if the new Cold War between China and America feels like it is getting steelier by the month, despite President Biden being in the White House rather than Donald Trump. Taiwan is still a potential flashpoint for Hot War, both territorially and technologically, thanks to Taipei’s predominance in the global silicon chip supply chain.
“If growth is unlikely (or least relies on wanton Government borrowing and overspending) then inflation still lurks as a possible outcome.
“And yet the Fed will not want to tighten policy too far, too fast, especially as financial markets seem far from pleased. Having become accustomed to a clear central bank message for well over a decade – namely that rates are going lower and staying there – even talk of higher borrowing costs, less liquidity or both is leading to a wobble in commodity prices, a minor stumble in stock markets and a move higher in volatility indices such as the VIX.
“What is odd, among all of that, is how the US ten-year Treasury yield seems to be trending lower again.
Source: Refinitiv data
“This is the last thing you would expect if inflation is coming, especially when yields are already miles below the current rate of increases in the cost of living.
“Yet these trends may not be as mutually exclusive as investors might think.
• The Fed is still running QE flat out to massage yields lower.
• There is more uncertainty now over its policy direction than there has been for some time.
• Investors seek havens, like bonds, at times of concern.
“Perhaps the bond and stock markets are getting ready for the return of volatility and bumpier times ahead. But then the chances of the Fed raising rates or hauling in QE may recede further, as the end of the debt-fuelled bull market and economic upturn would surely be seen as deflationary and any shock-and-awe policy response would surely have inflation – or at least staving off deflation - as its ultimate goal.”
