DEBT FUNDING, INFLATION, AND GOLD / MACLEOD FINANCE

Debt funding, inflation, and gold

Even though the Fed is expected to reduce its funds rate in a week’s time, the inflation outlook is worsening rapidly, which is why the dollar is weakening and gold rising.

ALASDAIR MACLEOD

Governments are attempting to contain their long-term debt funding costs, which are due to a combination of a lack of investor demand and bond yields which have risen sharply in recent years. 

The extra funding cost of long-term maturities over short-term rates is illustrated in the US Treasury yield curve in the chart above. 

In the case of US treasuries, auctions with longer maturities tend to be disappointing. 

Doubtless, if longer term funding is used to ensure the debt maturity profile remained containable with respect to maturity roll-overs, long-end yields would be considerably higher.

This explains why the Fed approved a move to reduce the supplementary leverage ratio imposed on big bank balance sheets so long as the extra balance sheet space is invested in treasuries. 

However, this will only increase bank demand for short-term debt, mainly T-bills maturing in less than a year. 

But it is worth remembering that this finance is bank credit and not investor-sourced, making it inflationary. 

But reducing the supplementary leverage ratio is only part of the story.

Almost certainly, the Fed will reduce its funds rate by .25% in a week’s time. 

Under political pressure, further rate cuts can be expected. 

This will reduce the cost of T-bill funding even further. 

A win-win for Trump —or is it?

At this point, it should be made clear that debt is not a bad thing. 

What matters is how it is funded and how it is used. 

Simply put, if savers increase their savings to invest in government debt it reduces consumer demand for goods so is deflationary. 

But if government uses the debt raised to spend in the economy it balances the deflationary effect of an increase in savings.

This is why China’s and Japan’s economies with their high consumer savings rates exhibit low inflation compared with the high-spending low-saving Anglo-Saxon consumers.

Alternatively, if government debt is bought by banks creating credit out of thin air, which is what’s happening here, then it is inflationary. 

It debases the value of credit in terms of its purchasing power. 

Because raising extra debt funds excess government spending over its revenue receipts, monetary debasement is obvious. 

However, it takes a little time for the effect to be reflected in government statistics.

Unfortunately, monetary debasement coincides with Trump’s trade tariffs on imported goods, raising input prices for consumers. 

The combination of bank credit expansion to fund budget deficits and higher trade tariffs is a recipe for an inflation crisis. 

Yet, macro-economists seem to be unaware of this reality.

At the same time, Main Street is struggling to survive profitably, with the economy already in recession. 

Take the US budget deficit out of nominal GDP to get a true picture of whether the non-financial private sector is growing or not, and you will find it is already in recession. 

This leads to declining revenues for the government and increasing welfare commitments raising the budget deficit and its required funding even more.

Therefore, the US Treasury faces a classic debt trap, whereby its funding requirements exceed the notional tax revenues to cover the notional cost. 

It can only lead to a buyers’ strike, higher bond yields, and a seemingly endless bear market in treasury bonds.

Combined with the impact of higher consumer prices reflected in a rapidly weakening dollar, eventually current declines in the Fed’s funds rate will have to be reversed and raised considerably if the dollar is to be stabilised. 

In their different ways, this outlook is shared by other G7 nations but nowhere is it more important than for the currency upon which all others are based, however loosely.

Perhaps this reality for the dollar is beginning to dawn on the macro-economic community, which is why gold is rising strongly and taking silver with it. 

In which case, it is a reassessment which is still in its early days.