Deficits Are Forcing the Fed Back Into Expansion | Lyn Alden

Key Concepts

• Quantitative Tightening (QT) and Quantitative Easing (QE): Federal Reserve's monetary policy tools involving the reduction (QT) or expansion (QE) of its balance sheet.
• Fiscal Deficits: The difference between government spending and revenue.
• Tariffs: Taxes imposed on imported goods.
• "Nothing Stops Us" Train: A framework suggesting that fiscal stimulus and other factors are preventing a significant economic downturn.
• Stagflationary Effect: A combination of stagnant economic growth and high inflation.
• Misery Index: The sum of inflation and unemployment rates.
• K-Shaped Economy: An economy where different sectors or income groups experience vastly different outcomes.
• Monetary Base vs. Broad Money: Base money is the physical currency in circulation plus commercial banks' reserves held at the central bank. Broad money includes base money plus commercial bank deposits.
• Interest on Reserves (IOR): The interest rate paid by central banks on reserves held by commercial banks.
• Debasement Trade: The strategy of investing in hard assets like gold and Bitcoin to hedge against the devaluation of fiat currencies.
• Standing Repo Facility (SRF): A tool used by central banks to provide overnight liquidity to financial institutions.
• Treasury General Account (TGA): The U.S. Treasury's primary bank account at the Federal Reserve.
• Mortgage-Backed Securities (MBS): Securities backed by pools of mortgage loans.

Fiscal Outlook and Tariff Impact

The discussion begins by noting that while the trade is not accelerating, it is still moving at a fast pace. The Federal Reserve is expected to end quantitative tightening (QT) soon, potentially at the upcoming meeting, and then gradually increase its balance sheet in the coming months. The speaker cautions against hyperbolic claims of "QE infinity" or hyperinflation, emphasizing that a mild balance sheet increase (4-5% annually) is significantly different from the massive QE seen during COVID-19.

Key Points:

• Fiscal Dominance: Fiscal policy is playing a larger role than usual, especially outside of recessions, influencing macroeconomics significantly.
• Tariffs as a "Speed Break": While not capable of stopping the "train" of fiscal spending, tariffs can slow it down. This is because they represent a unilateral tax increase that bypasses congressional polarization.
• Supreme Court Review: The Supreme Court's upcoming decision on tariffs is a significant wildcard. Previous court rulings have gone against the administration, but the Supreme Court's composition is different.
• Stagflationary Effect of Tariffs: Tariffs contribute to a stagflationary effect, characterized by muted economic activity (as seen in ISM PMIs) coupled with high "prices paid" components. This is unusual, as high prices paid typically correlate with rapid expansion.
• Magnitude of Tariff Impact: Tariffs, amounting to a few hundred billion dollars annually, are not a "game-changer" for a large economy but are material and impact an approximate $2 trillion deficit.
• "Big Beautiful Bill" and 2026 Impact: Stimulative fiscal impulses from this bill are expected to materialize in 2026.
• Fiscal Impulse and GDP: Critics point to slowing government expenditures as a percentage of GDP since 2021. However, the fiscal component is seen as offsetting other recessionary indicators, creating a "higher floor" for the economy.
• Nominal GDP Fueling: Fiscal deficits directly fuel nominal GDP, even with offsets. The expectation is for both nominal deficits and nominal GDP to remain elevated compared to the 2010s.

Interest Payments and Economic Growth

The conversation shifts to the impact of rising interest payments on debt. With higher interest rates (4-5%) on government debt compared to five years ago (near zero), the flow of these payments into the economy is examined.

Key Points:

• Stimulatory Impact of Interest Payments: Interest payments are considered less stimulatory than direct stimulus checks or tax credits, as they primarily benefit higher-wealth consumers whose spending is less tied to fluctuating incomes.
• Impact on Seniors: A significant portion of interest payments goes to seniors, for whom this income is a substantial part of their total income, materially affecting their spending.
• Intergenerational Spending: Seniors often spend on behalf of younger generations, assisting with major purchases like houses, weddings, or vehicles.
• Shift in Regime: This is a different economic regime compared to the 40-year structural decline in interest rates.

Government Shutdown and its Impacts

The ongoing government shutdown is discussed, with the speaker noting its potential to become the longest in U.S. history.

Key Points:

• Short-Term vs. Long-Term Impact: For the normal length of a shutdown, the macroeconomic impact is not material. However, as it extends into the second month and affects essential programs like food stamps, the situation changes.
• Social vs. Economic Impact: The social impact on lower-income segments of the population is considered higher than the immediate economic impact on large macroeconomic figures, as the top 20-30% of income earners drive a significant portion of spending.
• Indirect Impacts: Delays in SEC filings and potential impacts on air traffic control due to furloughed staff are noted as indirect consequences.
• Materiality with Duration: The longer the shutdown persists, the more material its economic impact becomes.

K-Shaped Economy and Growth Outlook

The discussion explores how a "K-shaped economy," driven by dynamic fiscal deficits and AI-related capital expenditures, might be masking underlying economic weakness.

Key Points:

• Weighing Factors: Fiscal deficits and AI capex are significant forces that weigh against other indicators like low PMIs and an inverted yield curve, which would typically signal a recession.
• Emerging Market Characteristics: Fiscally dominant economies can exhibit characteristics of emerging markets, where unemployment may not spike, but individuals feel poorer due to debasement, rising costs, and a lack of tangible growth.
• Misery Index and Consumer Sentiment: While the misery index is in check, consumer sentiment remains near record lows due to an affordability crisis.
• Sectors on the Weaker Side: Private equity, venture capital, private credit, and commercial real estate are identified as areas experiencing weakness.
• Fiscal Stimulus Offset: Large fiscal deficits, even if not directly targeting high-propensity spenders, provide a stimulus force that offsets underlying weaknesses.
• Nominal vs. Real GDP: The traditional focus on real GDP growth might be less relevant in an environment of high inflation, where nominal GDP growth could be positive but real GDP growth negative. The "misery index" is suggested as a more pertinent metric.
• Sector-by-Sector Analysis: A sector-by-sector approach is recommended for understanding the economy, similar to analyzing per capita metrics in countries with high population growth.
• Labor Market Nuances: Changes in the labor force, particularly the reduction in immigration, are contributing to a tightening labor market and a lower "break-even rate" for inflation. This is seen as a factor influencing the Fed's focus on the labor market.
• Persistent Above-Trend Inflation: The speaker anticipates that inflation will remain mildly above the Fed's 2% target, partly due to tariffs and companies eventually passing on costs.

Federal Reserve Policy and Balance Sheet

The role of the Federal Reserve's balance sheet and the potential end of quantitative tightening are discussed.

Key Points:

• Fed's Tools and Fiscal Inflation: Traditional monetary policy tools (like interest rate hikes) are less effective against fiscal-driven inflation. The Fed's tools are primarily designed for bank lending channels, which were not the source of the current inflation.
• Asymmetric Critique of Fiscal Policy: The Fed has been more willing to call for fiscal stimulus than to critique fiscal policy's role in inflation. This may be to maintain market confidence.
• Immigration and Wage Growth: Unleashing immigration is seen as a significant factor in bringing down inflation by tempering wage growth, potentially more so than Federal Reserve rate hikes.
• Fed's Role in Wage Growth: A criticism of the Fed is that it is more concerned with blue-collar wage growth (which it seeks to curb) than with asset price inflation.
• Balance Sheet Relevance: The Fed's balance sheet is becoming relevant again as quantitative tightening nears its end.
• 2019 Repo Spike Analogy: The September 2019 repo spike is used as a comparison, highlighting a liquidity shortage driven by an oversupply of T-bills relative to other liquidity.
• Transition to Balance Sheet Increases: The Fed is likely to end QT and move towards mild balance sheet increases, focusing on T-bills rather than longer-duration assets. This is described as "anti-deflationary" or liquidity-supportive rather than stimulatory.
• Size Matters: The magnitude of balance sheet changes is crucial. A 4-5% annual increase is different from the massive QE during COVID.
• Treasury Issuance and Fed Purchases: The Treasury's shift towards issuing more T-bills, combined with the Fed's potential to become a buyer of T-bills, could be stimulative. This is seen as a "mildly emerging market characteristic."
• Financial Repression: The current environment is characterized by financial repression, where the Fed's actions (reducing MBS, increasing Treasury holdings) favor the sovereign government.
• Pre-GFC Regime: The economy is moving towards a regime similar to the pre-Global Financial Crisis era, with persistent but slow balance sheet increases, but from a higher percentage of GDP and bank assets.
• Interest on Reserves (IOR) as a Political Topic: The role of IOR in setting rates and its impact on banks is becoming a political issue.

Debasement Trade and Asset Allocation

The evolution and current state of the "debasement trade" are discussed, focusing on hard assets like gold and Bitcoin.

Key Points:

• Debasement Trade in Effect: The debasement of fiat currencies continues, with the trade going through different "seasons."
• Evolution of the Trade: The trade began with the repo spike in late 2019, intensified with COVID-era stimulus, saw a pullback in 2022 with QT and fiscal contraction, and is now re-emerging with activist Treasury issuance and a return to balance sheet expansion.
• Gold's Performance: Gold has had a strong year but may be overextended in the near term.
• Bitcoin's Potential: The Bitcoin cycle is not considered over, with expectations of higher prices in 2026, potentially seeing a rotation from gold.
• Equity Pockets: Select emerging markets and banks are identified as potential beneficiaries of the debasement trade. Banks are seen as buffered by high cash and Treasury holdings and benefiting from the K-shaped economy.
• Less Cyclical Nature: The debasement trade is less tied to the business cycle and represents a higher floor for asset values.

Conclusion

The conversation highlights a complex economic landscape where fiscal policy and balance sheet dynamics are playing a dominant role, potentially masking underlying weaknesses. While traditional monetary policy tools are less effective against fiscal-driven inflation, the Federal Reserve is navigating a transition from quantitative tightening to a period of mild balance sheet expansion. The debasement trade remains a relevant strategy, with gold and Bitcoin expected to see further price appreciation, albeit with potential rotations and varying timelines. The speaker emphasizes the importance of looking beyond traditional metrics and considering sector-specific performance and per capita impacts in this evolving economic environment.