8/29/24 Roundup: Fed Pivot & Fiscal Dominance

source: FRED

As Lyn Alden points out, this means that today’s Fed funds rate is actually stimulative to large parts of the economy, as it represents record transfer payments from the public sector to the private sector in the form of higher public debt interest expense. Indeed, interest expense now exceeds military spending and is a large contributor to today’s record fiscal deficits.

These economic conditions — high (>100%) debt-to-GDP, large (>5%) fiscal deficits, high (>5%) interest rates — have never been present in the US in the past. Record debt-to-GDP and fiscal deficits could be a factor for why the US economy was resilient in the face of the rate hiking cycle from 2022-2024 and may not experience a recession as a result of high interest rates this time.

Second, notice how since 1980 every rate cutting cycle has led to a lower low in the Fed funds rate at the bottom of the cycle. Lyn again notes that unless we reach a lower low in interest rates this cycle, spurring a wave of mortgage refinances, the economy similarly might not be very sensitive to rate cuts this cycle, just as it wasn’t very sensitive to rate hikes.

This is fiscal dominance — when fiscal deficits are so large that monetary policy loses its effectiveness.

So if the seemingly imminent rate cutting cycle isn’t likely to impact the US economy except on the margins and in select pockets — such as commercial real estate with floating rate debt that needs to be refinanced, banks who are competing with money market funds for deposits, or new autos which depend on financing rates for affordability — who, and what assets, will it impact?

While monetary policy might not have the same impact on the domestic economy in an era of fiscal dominance, it still has a significant impact on foreign economies and capital flows. As we saw with the yen carry trade unwind, when US rates are 5.5% and Japanese rates are 0% for an extended period of time, imbalances can build up in the system. As interest rates in the US are lowered and catch down to interest rates in the rest of the world, capital is likely to flow out of US assets and into global assets on the margin. Moreover, high rates in the US contributes to a strong dollar, which is an economic headwind for the rest of the world — especially emerging markets with high dollar-denominated debts, like Columbia and Argentina — and a headwind to asset prices. As rates come down, that headwind should turn into a tailwind.

Indeed, in the wake of the yen carry trade unwind, we have already seen the DXY — the dollar index, a measure of dollar strength relative to a basket of foreign currencies — turn lower (blue line):