The USA has a problem with rising debt. The total public debt as a percent of gross domestic product is around 120%, after rising as high as 133% during 2020 due to pandemic spending.
Last month, Moody’s “lowered its outlook on the U.S. credit rating to negative from stable, citing large fiscal deficits and a decline in debt affordability.” (Reuters)
There are four ways a country can reduce debt: cut spending, raise taxes, “inflate away the debt,” or default on its sovereign debt.
Amid financing countries fighting wars, modernizing the military, dealing with the climate crisis, and keeping the world economy engine going to avoid another deflationary cycle, the USA cannot cut spending but must increase it. Cutting spending is not a solution.
Raising taxes is a suicidal move for any political party, especially after a long period of high inflation and with a large part of the population struggling with high prices. A default would mean domestic and even worldwide chaos and would not happen.
Inflation versus price level
Even if the inflation rate drops to zero, prices will remain high. In the last 78 years, there has been no noticeable decline in the price level, except during GFC, when the CPI turned negative for a short period, as shown in the chart below.
As the chart shows, despite a drop of YoY CPI to 3.24% from the highs of last year around 9% (second chart), the price level continues to grow (top chart), while the 3-year inflation rate is at 18.2% (bottom chart). We will focus on the comment on the bottom chart about the Fed delaying raising rates for a year.
Initially, like many others, I thought the Fed had made a policy error by expecting “transitory inflation.” But after some careful thinking, I dismissed this possibility. They are too smart to make this type of error. Keeping interest rates low while inflation was rising was a deliberate move because the only way left to reduce a rising debt is by inflating it away.
In essence, the Fed decided to let inflation rise, and the policy to stop it from getting out of control was to lower the price level of the commodity that contributes most to its rise: crude oil. The Fed kept interest rates high to have room to lower them later. The policy of selling crude oil from SPR was highly effective.
The Fed started hiking rates in March 2022, and in two months, the inflation rate peaked at 9% while the interest rate was 1.6%. Then, through relentless sales of crude from SPR, inflation started falling while rates were still rising to slow the rate. The combination of rising rates and selling crude was a successful policy. Now what?
Inflation must remain at a high enough level to counteract a growing debt. This means the Fed must cut soon to reignite inflation.
A crude estimation yields that for the debt to fall to 70% of GDP, inflation must stay above 4% for about 15 years. This assumes no real growth. If the real growth is positive, then the drop to 70% could be accomplished faster, but many unknown variables can cause divergences from the target.
The speculation here is that the Fed will cut, not because they are worried about growth or employment, but to inflate the debt by reigniting inflation. They will find another narrative when inflation rises again to justify staying behind the curve. They are smarter and more capable than most think.
How are asset prices going to respond under this scenario?
After the rate cuts, stocks will rally to new all-time highs, and bonds will rebound. Gold will fall along with the US dollar, but the relative exchange rate of the latter will depend on the actions of other central banks and possibly G-7 arrangements.
After the new uptick in inflation, bonds will enter a new downtrend, but stocks could move sideways until a new rate-hiking cycle starts. Gold will probably rebound when inflation increases, but the rate of change will depend on the US dollar. Therefore, we can only have some certainty about bond market behavior under this scenario; moves in equities, gold, and the US dollar could be unpredictable. There is no clear pair trade here, as some analysts might suggest. The likelihood of a bond rebound, a top, and then another downtrend, or directional trades in bonds, is highest in this scenario.
There is no easy way out of high debt. The policy will affect the capital markets, the consumer, and the standard of living. However, the risks of not inflating the debt are higher. This is why I believe the scenario I described in this article is realistic.
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