Throughout the second half of 2023, the view began to take hold in the market that the U.S. Federal Reserve would eventually deliver, achieving both a slowdown in aggregate demand and growth without reaching stagnation, and a consolidation of inflation around the long-term target. After the fastest interest rate hike in history, job creation had shown a clear deceleration, while between June and December the Fed's preferred inflation measure seemed to have stabilized at a pace consistent with 2% per annum. Investment had been hit, especially in the real estate sector, but private consumption nevertheless maintained a surprisingly robust pace, particularly in the services sector, intriguing analysts. As of December, the monetary authority's projections predicted that 2024 would finally be the year in which the macro "soft landing" would materialize; the combination of high real rates and the depletion of surplus savings accumulated by households during the pandemic would bring consumption to a more sustainable pace, taking pressure off the labor market and prices. Then, with inflation now firmly on track, it would be timely to begin the long-awaited process of lowering rates.
Recently, however, the picture has begun to take a different shape; during the first quarter of the year, core inflation picked up, job creation accelerated again, and personal spending continued to grow at a rate above the long-term potential, against a deepening decline in the savings rate. At the same time, the optimism of a market that was already beginning to take for granted a soft landing in 2024 and at the same time marveling at the possibilities generated by the irruption of artificial intelligence continued to drive stock prices, inflating the financial wealth of families and companies. According to the latest estimates from the Atlanta Fed, the US economy would have grown at an annualized rate of 2.5% in the first quarter, with the expansion of private consumption explaining 2.1 points of the total.
In this context, Fed Chairman Jerome Powell has reiterated in his recent speeches that there is still "not enough evidence" in favor of the economy having reached the point where contractionary monetary policy can begin to unwind. As long as there are no clear signs of a slowdown in employment and consumption, as long as the major stock indices remain at record highs, and as long as inflation does not stabilize decisively around target, why would monetary policy rates be lowered? The answer is simply that they should not be lowered, at least in the short term. But how long can this dynamic be extended? What is the driving force that continues and can continue to drive consumption above potential in a context of historically high real rates?
Argentines have lived for decades with the answer to this question; the fiscal impulse. The FED has been reducing its balance sheet for 2 years now, selling assets in the secondary market to absorb liquidity from the economy, trying to placate demand and inflation. However, the Federal Treasury has pursued a policy totally contrary to these efforts; in fiscal year 2023, with the economy clearly already in a growth phase, the Treasury's financial deficit reached 7.8% of GDP, an excessively high value for any economy that is not in need of countercyclical policies. When evaluating how this huge hole in the accounts has been financed, we see that the issuance of government securities exceeded 2.7 trillion dollars in the last 12 months, equivalent to more than 10% of GDP. At the same time, we see in the same period a drop of 1.8 trillion dollars in the stock of excess reserves that banks deposit with the FED in the form of passive liabilities, and a similar increase in the holdings of government securities by money market funds and households. Connecting these last points, the conclusion is clear; the Treasury has not only taken the imbalance between revenues and expenditures to unjustifiable levels, but has also financed it with monetary issuance; the FED takes liquidity out of the economy through one door, but the Treasury takes it in through another, draining the banking system's excess reserves in the process. In this way, a contractionary monetary policy conflicts with a strongly expansionary fiscal policy, which sustains aggregate demand and price pressures.
The new question is now, how sustainable is this? After all, we are talking about the world's leading economy, printing the world's most in-demand currency, with a government that has historically established an immaculate reputation as a debt payer. The U.S. bond has been and continues to be, in the eyes of the market, the risk-free asset par excellence. However, that reputation is based on confidence, and the widespread conviction that the stability of the fiscal accounts will be maintained over the long term. At present, this long-term stability does not look to be on track. According to the latest estimates of the Congressional Budget Office, if the current course is maintained (i.e., with no changes in legislation), the financial deficit would rise from 2 to 2.7 trillion dollars over the next 10 years, with the interest burden of the public debt and social security and health spending being the main sources of spending expansion, in an economy facing a complicated dynamic of population aging. In turn, the federal debt held by the public would rise from the current 98% of GDP to surpass the historical record of 106% (touched during World War II) as early as 2028. By 2054, the burden would reach 166% of output, a figure impossible to finance in practice. Now, the CBO estimated the above figures under the assumption that all payments, including those to Social Security beneficiaries, are carried out as planned under current law and demographic projections. However, they conclude that if the benefit amounts or the wage tax rate are not altered, the trusts from which the pension system is financed would be exhausted by 2033. While in practice it is not serious to think that the U.S. economy can get to this point without changing course, it is clear that the course must certainly be changed, and sooner rather than later.
It is not necessary to look 9, 10 or 30 years ahead to find problems. It is clear that fiscal and monetary policy objectives cannot be dissociated indefinitely without generating macro turbulence. The monetization of the fiscal deficit and the injection of liquidity it means has already changed the baseline scenario of activity and inflation for 2024, calling into question the rate cuts still expected by both the markets and the monetary authority itself for this year.At the same time, the continuous draining of excess reserves of financial entities leads to think about what may happen when reaching a point of exhaustion in this stock; the logical thing would be greater difficulties in the placement of new securities for the treasury, generating additional upward pressures on the yield curve and the crowding out of credit to the private sector. In turn, the Fed would lose visibility of liquidity levels in the financial system.
In this scenario, the likelihood increases that one or more sectors will begin to encounter balance sheet problems. The longer it takes policymakers to demonstrate their willingness and ability to act in order to start cleaning up fiscal accounts, the higher the probability of an episode of distrust that affects the value of government securities and, consequently, the wealth of companies and families, as perceived by the markets. In turn, a hasty adjustment of accounts will become increasingly imperative, which will have a greater probability of significantly affecting activity levels. All of the above may lead to a downward correction scenario in the stock markets. Fiscal irresponsibility has already taken the U.S. economy from soft landing to no landing, and there are certain risks of a hard landing. However, President Biden is on the campaign trail, and has already promised a new student financial relief plan in the battleground state of Wisconsin, which if implemented would have a fiscal cost in excess of $50 billion. His opponent has also shown no signs of valuing an adjustment. Meanwhile, the stock markets continue to party. It remains to be seen who will be left when the waiter arrives with the bill.
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