The Reality of Financial Dominance
Doug Nolan
The federal deficit for the first quarter of the new fiscal year was reported at $573 billion, up 61% y-o-y. Washington borrowed 45 cents of every dollar spent during the quarter. After the passage last month of the $900 billion stimulus legislation, estimates were placing this year’s deficit above $2.3 TN.
The Biden administration Thursday released details of its Covid stimulus package with a price tag of $1.9 TN. Goldman Sachs has since increased its estimate of the eventual size of this stimulus to $1.1 TN from $750 billion.
Goldman believes tough negotiations are in store to garner the necessary Republican votes in the Senate. Democrats could push some of this spending through the budget “reconciliation” process requiring only a simple majority, although this would come with delays and other issues.
The President-elect also announced a second major package addressing taxes and infrastructure would be coming later in the year.
It appears likely that this year’s fiscal deficit will now even exceed last year’s unprecedented $3.1 TN.
The country is hurting, and social tensions are boiling over. I understand the argument that a deeply divided country can’t commence a healing process until its citizens get their feet back on the ground with confidence the economy is moving forward.
Yet I dismiss the argument that low interest rates create the opportunity to assume larger debt loads. It’s a tragedy we came into this pandemic with such indebtedness and financial instability.
Our federal government is in the process of expanding debt by more than 30% of GDP in only two years. Hopefully not at double-digit annual rates, yet massive deficit spending is inevitable as far as the eye can see.
Importantly, Washington is running massive deficits despite both record stock prices and corporate debt issuance – in the face of about the loosest financial conditions imaginable.
How enormous will deficits balloon when this historic financial Bubble bursts?
Are $5.0 TN annual deficits an unreasonable guesstimate? No worries, apparently.
There’s always the “whatever it takes” Federal Reserve balance sheet. In the financial and economic crisis scenario, does the Fed boost Treasury, MBS, corporate bond and EFT purchases to, say, $500 billion monthly?
Two headlines from Powell’s Thursday Princeton zoom call: “U.S. Federal Debt Not on Sustainable Path” and “High Public Debt Does Not Affect Monetary Policy.” Perhaps a more pertinent caption would read, “Monetary Policy Fomenting High Public Debt.”
I might be persuaded to believe in the most extreme circumstances (i.e. war or during acute financial crisis) there may be justification for central banks temporarily pegging long-term market yields.
Today is not such a scenario. The system is currently in a most desperate need of some market discipline. At this point, only the markets can keep Washington from completely bankrupting our government with unmanageable debt.
Markus Brunnermeier, director of the Bendheim Center for Finance at Princeton:
“Let me move on to the next topic from price stability to financial stability, which is also a major concern for you and the Fed more generally. There is also this concept out there of financial dominance. So, if the financial sector - of course it’s very sound at this point but there might be over-leveraging going on on the corporate side – do you see that there is some threat from financial instability which might limit what monetary policy you can undertake at some point down the road? And do you think the macro-prudential tools the U.S. has are sufficient to avoid such a financial dominance circumstance?"
Fed Chair Jay Powell:
“I would say we don’t feel any pressure from financial dominance… If financial dominance is the reluctance, or even the inability, of a central bank to tighten policy because of the leverage in the private sector – we don’t feel that.
Our non-financial corporate sector did go into this downturn with relatively high leverage, but at these low interest rates the interest payment are actually not at terribly high level by historical standards – they're sort of at a normal level.
We have not seen the big uptick in defaults that we thought we might see… It’s just not something we are feeling or have ever felt, really. When the time comes to raise interest rates we’ll certainly do that – and that time, by the way, is no time soon.”
Noland comment:
I can only hope this is an issue of semantics.
The Fed hasn’t employed traditional tightening measures since their 1994 rate increases punctured a highly levered speculative Bubble (bond and derivatives markets).
Fed funds ended 2002 at 1.25%, despite double-digit mortgage Credit growth. With household mortgage Credit having expanded 75% in five years in clear Bubble excess, Fed funds ended 2004 at 2.25%.
After cutting rates to zero in late 2008, rates began 2018 at only 1.25%. Powell’s attempt to normalize policy rates ended rather abruptly at 2.25%, with a late-2018 bout of de-risking/deleveraging forcing the new Fed Chair to “pivot” right back to ultra-easy.
The key issue throughout this cycle has been speculative leverage as opposed to over-indebted corporations. The Fed obviously “feels pressure” – as its $3.1 TN response to March’s market dislocation demonstrates.
It was not the economy forcing what seemed at the time daily boosts to the scope of the Fed’s emergency balance sheet operations. It was, instead, the clear and present danger of an unraveling of unprecedented speculative leveraging behind previously unimaginable Fed liquidity injections.
It can be called “financial dominance” or the layperson’s “trapped,” but markets operate today with high confidence that the Fed has no alternative but to maintain ultra-easy conditions – zero rates, massive ongoing balance sheet growth, and whatever it takes market liquidity backstopping. “Financial Dominance” is the Bubble’s lifeblood.
Brunnermeier:
“The public debt level, of course, has reached record highs. If you look at the CBO forecast, it’s going up tremendously over the next few years… How will this impact monetary policy… It might be constraining through fiscal dominance of monetary policy down the road.
And how important do you see the independence of the central bank, of the Fed, that at that time – when it has to step on the brakes a little bit – that it can actually raise interest rates? Do you think it’s very important – not only for the Fed but for other central banks around the globe as well? How would you stress the importance of independence…?"
Powell:
“The U.S. is not on a sustainable path at the federal government level in the simple sense that the debt is growing substantially faster than the economy. That means by definition it is unsustainable.
That’s not to say that the level of debt is unsustainable. It’s not unsustainable and it is far from unsustainable. I think we’re a long, long way from fiscal dominance in the United States, if we ever get to that place.
It is certainly not a factor we consider in any way at this time. So high debt in no way impacts monetary policy now. We are squarely focused serving the public through to achieve maximum employment and stable prices.
My strong view is that central bank independence is an institutional arrangement that has served the public well… I frankly feel that is well understood among elected representatives – on both sides of the aisle people do understand that having an independent central bank really does help, particularly in times of crisis, but also through the business cycle where you can really be focused on serving all the American people and ignore political considerations completely.”
Noland Comment:
The system is today one unexpected spike in market yields away from mayhem. Why are current deficits not alarming, when past deficits a fraction of today’s size were recognized as dangerous and unsustainable?
What gives Powell the confidence that “we’re a long, long way from fiscal dominance”? One reason: because of contemporary, experimental monetary policy – more specifically the introduction of prolonged periods of zero rates and central bank asset purchases.
I have much less confidence in debt sustainability than Powell, as I seriously question the sustainability of central bank inflationist doctrine. I don’t believe the Fed can continue to inflate “money” and manipulate the markets without ensuring at some point one catastrophic market reaction/adjustment. Excess, distortions and imbalances will mount until something snaps.
Brunnermeier:
“Hopefully the crisis will be behind us soon, with the new vaccines coming out. At some point we’ll have to start thinking about exit. I know that some of your colleagues – and even you - said it’s too early to even think about exit.
But perhaps at some point we have to start to think about exit. I was wondering are there any lessons from taper tantrums – certain things we should avoid because taper tantrum was very detrimental to other economies outside the U.S. What are the lessons from the past experience…?”
Powell:
“Now is not the time to be talking about exit. I think that is another lesson of the global financial crisis is be careful not to exit too early. By the way, try not to talk about exit all the time if you’re not sending that signal because markets are listening.
The economy is far from our goals, and as I’ve mentioned a couple times, we’re strongly committed to our framework and to using our monetary policy tools until the job is well and truly done. The taper tantrum highlights the real sensitivity that markets can have about the path of asset purchases.
We know we need to be very careful in communicating about asset purchases… We will, of course, be very, very transparent as we get close. I would just say this on the current situation, when it does become appropriate for the committee to discuss specific dates - when we have clear evidence that we’re making progress toward our goals – and that we’re on track to make substantial further progress towards our goals – when that happens and we can see that clearly we’ll let the world know.
We will communicate very clearly to the public and we’ll do so, by the way, well in advance of active consideration of beginning a gradual tapering of asset purchases. So, that’s how we’re thinking about that.”
Noland Comment:
“Be careful not to exit too early” is a “lesson of the global crisis”? You can’t be serious?
The Fed doubled its balance sheet to $4.5 TN between 2011 and 2014 in a non-crisis environment.
This was after formally communicating an “exit strategy” in 2011.
Between 2008 and 2014, Fed holdings surged from $860 billion to $4.5 TN. At that point reducing assets to $3.72 TN doesn’t qualify as either “early” or an “exit,” especially when the Fed quickly reversed course in 2019.
At this point, I doubt an “exit” will ever be possible.
Count me skeptical of the nice scenario of the “very transparent” Fed clearly communicating an approaching taper to a calm and rational marketplace. We’re so beyond that. The Federal Reserve’s life is about to turn much more complicated and challenging.
Inflation risk is the highest it’s been in years.
The 10-year Treasury “breakeven” inflation rate added a couple more basis points this week to 2.09%, the high since October 2018.
Commodity prices continue to rally, with the Bloomberg Commodities Index closing Friday near one-year highs. Services and manufacturing surveys indicate heightened price pressures.
Yet my main point is different.
The world is awash in liquidity.
Moreover, the dollar has weakened, and the central bank overseeing the world’s reserve currency is trapped in reckless monetary inflation. This backdrop has granted countries around the world the flexibility to recklessly inflate their money and Credit. I would argue global “money” and Credit are unhinged like never before. And it’s no longer hypothetical.
Global central bank “money” is solidly on a trajectory that ensures Acute Global Monetary Disorder.
Does this ensure accelerating general price inflation?
Not necessarily. There remains the possibility for the bursting Bubble scenario with collapsing asset prices, de-leveraging, illiquidity and resulting deflationary pressures.
But after what was experienced in 2020, we must assume global central banks would respond in concert with multi-Trillions of additional monetary inflation.
We’ve reached the point where a particularly problematic circumstance would appear a relatively high probability scenario: central banks being forced by synchronized global de-risking/deleveraging to move early and aggressively to flood the system with liquidity.
Central banks, for the first time, would be flooding a system with liquidity despite increasingly entrenched inflationary pressures and biases. General price inflation could really catch fire.
January 13 – Bloomberg (Steve Matthews and Vivien Lou Chen):
“Federal Reserve officials are beginning to split over when they may need to start pulling back on their massive monetary stimulus, drawing nervous glances from investors who remember how markets were roiled during the 2013 taper tantrum.
In the past week, four of the Fed’s 18 policy makers have publicly raised the prospect they may discuss reducing bond buying -- currently running at $120 billion a month -- by year’s end.
In contrast, several others have called the debate premature and Fed Vice Chairman Richard Clarida, the most senior central banker to weigh in, has said he doesn’t expect any changes before 2022.”
Powell may have tried to throw cold water on taper talk, but this issue is anything but resolved. Inflationary pressures are mounting, while egregious market speculative excess could not possibly be more conspicuous. M2 “money” supply was up $3.842 TN, or 25%, over the past year.
With the Democrats in charge, already massive deficit spending will be supersized.
It’s terrible to see our members of Congress living in fear. Any responsible central banker would look at today’s monetary environment and be panicked.
Another fascinating week in global finance. Interesting to see the People’s Bank of China and the Reserve Bank of India both moving to drain some excess liquidity.
EM equities Bubbles indicated some vulnerability, with major equities indices sinking 3.8% in Brazil and 2.1% in South Korea.
EM bond prices reversed lower.
EM currencies were generally lower for the week, with notable weakness in European EM currencies. European equities faced selling pressure, with most major indices down around 2%. Italian 10-year yields jumped eight bps on renewed political instability (see Europe Bubble Watch), as Italian banks were hit 3%.
The S&P500 dropped 1.5%, giving back most of its y-t-d gain. With its 2.3% decline, the Nasdaq100 is now down for 2021.
While speculation runs rampant at the fringe, the major indices are indicating vulnerability. Investment-grade and high yield CDS prices rose this week. The VIX jumped almost three points to 24.34, a notably elevated level considering equities are near record highs and there’s no major impending event raising the fear level.
January 15 – Reuters (April Joyner):
“Trading volume in U.S. equity options hit a new record on Friday… More than 49.5 million contracts traded during the session, Trade Alert said. Friday marked the expiration of monthly options contracts…
This year, some 416 million U.S equity options contracts have already traded over 10 sessions. That’s equal to the total options volumes over the first four months of 2004…”
Markets are appearing more fragile to me.
A historic mania faces a troubling reality.
The pandemic continues to spiral out of control, with risk that these virus variants worsen an already horrible situation.
The U.S. economy has notably weakened (i.e. employment, retail sales, small business confidence and consumer confidence).
And while the bullish consensus sees only a few months until vaccines reignite recovery, there are major issues with the vaccine rollout as well as deepening scars as the U.S. pandemic downturn approaches its one-year anniversary.
Mainly, I sense Bubble vulnerability.
Things evolved into an out-of-control liquidity-fueled mania, within a backdrop acute economic, social and political instability.
We’ve lost sight of the combustibility of this mix.
When markets inevitably succumb, the dark social mood is poised to exacerbate the downturn.
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