What the Combination of Fiscal and Fed Policy Can Tell Investors (June 21, 2024)

A new “monetization impulse” metric is rising as budget deficits expand and QT slows. 

By Lisa Beilfuss
June 21, 2024

The latest spate of economic data are alleviating concerns over inflation. But a new way of measuring the interplay between fiscal and monetary policy suggests the slowdown in price increases will be short lived. 

May price data broke the streak of renewed, and largely unexpected, upticks in inflation. From a month earlier, the consumer price index was the lowest since July 2022, the producer price index fell at the fastest pace in eight months, and the import price index fell for the first time in five months. 

This all points to a 0.06% month-over-month increase in the Federal Reserve’s favorite inflation metric, the core personal consumption expenditure index, says Omair Sharif of Inflation Insights. That would represent the lowest print since November 2019–outside of March and April 2020, when the government shut down much of the economy–and it would pull the year-over-year core PCE down to 2.56%.

While a welcome development, relief over cooler inflation numbers misses the forest for the trees. More important news is that the Congressional Budget Office in the latest week raised its 2024 budget deficit estimate to $1.9 trillion from a February estimate of $1.5 trillion. What is more, the CBO projects that debt held by the public will rise from $26.2 trillion at the end of 2023 to $50.7 trillion at the end of 2034. As a percentage of gross domestic product, debt is projected to rise from 97.3% in 2023 to 106.2% by 2027,  surpassing the prior record set just after World War II. The CBO says that ratio will rise to 122.4% by 2034–about 25 percentage points larger than it was at the end of 2023, and two-and-a-half times its average percentage over the past half century.

Alarming as they look, budget-deficit and debt-to-GDP estimates are probably too optimistic. As Joe LaVorgna, chief U.S. economist at SMBC Nikko Securities notes, embedded in the latest CBO projections are estimates of federal revenue hovering around a historically high 18% of GDP. That is a reasonable assumption if the unemployment rate averages just 4.4% over the next decade as the CBO expects. But an economic downturn would push unemployment higher and revenue growth would collapse, as the government would concurrently spend more on programs such as unemployment insurance, LaVorgna says.  

It is intuitive that rising government spending would spur inflation. That is despite arguments to the contrary by proponents of modern monetary theory, or MMT, and after fiscal and monetary largesse in response to the financial crisis of 2007-08 didn’t produce inflation. A 2022 paper from the Bank of International Settlements helps frame the current reality.   

The strength of the deficit-inflation link depends on what kind of fiscal-monetary policy regime is in place, the authors say. Specifically, a higher deficit is least inflationary under a "monetary-led" regime, where the fiscal authority acts prudently to stabilize public debt, the central bank is “highly independent,” and the central bank faces strong legal limitations on its ability to lend to the public sector. By contrast, the greatest inflationary effect occurs under a "fiscally led" regime, where fiscal policy is profligate and the central bank is constrained only in a limited way from lending to the public sector. 

Crucially, the paper’s authors found that the high inflation of 2021 and 2022 “appears more consistent with a fiscally led rather than a monetary-led regime.”

Solomon Tadesse, head of quantitative equities strategies North America at Société Générale, has been warning about the kind of regime shift in the U.S. that the BIS described. He set out to develop an empirical link between fiscal and monetary largesse and inflation, and introduced what he calls the “monetization impulse” in a report this month.

Here it may be helpful to revisit the idea of debt monetization. Readers might recall how Tadesse has previously framed the issue for Praxis. 

There is direct monetization, in the form of an irreversible transfer of money from a central bank to the government or a purchase of debt securities by the central bank upon issue in the primary market. Direct monetization tends to occur in war-torn or developing countries, resulting in hyperinflation linked directly to currency printing.

Then there is indirect monetization. In developed countries, laws constrain the level of central bank involvement in government financing. As Tadesse notes, the Banking Act of 1935 prohibits the Fed from directly purchasing bonds from the Treasury. The Fed instead executes open-market operations by buying and selling Treasuries on the secondary market and purchasing government debt via quantitative easing programs. 

A key point Tadesse emphasizes is that QE isn’t automatically monetization in that it represents a temporary debt transfer to the public books that is reversible through quantitative tightening, when the Fed lets maturing government bonds mature instead of reinvesting the proceeds. But a lack of follow-through with QT means the debt remains on the balance sheet and is effectively monetized.

With his monetization impulse Tadesse focuses on potential debt monetization, which goes beyond deficit financing by the Treasury to include all forms of monetization related to the funding of government programs, such as government bond purchase programs conducted by the Fed and accompanying temporary credit facilities.

A logical point for measuring potential maximum monetization is the size of the total federal debt financed by Fed banks, Tadesse says. That amounts to about $5.2 trillion, down from a peak of about $6.2 trillion in the first quarter of 2022. But while potential monetization is down from its recent peak, it is well above a pre-pandemic level of under $3 trillion and a pre-financial crisis level of under $1 trillion. 

The Fed is financing an increasing share of rising U.S. debt, jumping from about 5% of GDP historically to about 18% currently. QE-driven debt transfers account for the big rise, Tadesse says. At the same time, the central bank announced in April that it would slow the pace of QT this month–a hint the program is coming to an end after only about $1.7 of the roughly $5 trillion in pandemic-related debt has fallen off its balance sheet. The balance sheet stands at $7.3 trillion; for context, it was under $1 trillion before the 2007-08 financial crisis. 

The increase in potential debt monetization has caused money supply growth to skyrocket, Tadesse says. Over the post-pandemic period, debt (adjusted for real GDP growth) has gone up by an annualized 7.7%, while the monetary base, or M0, has risen 13% and M2 money supply has increased 73%. Over the post-GFC period since 2007, he says debt and money-supply growth rates have followed similar patterns. The point is that monetary growth in excess of inflation-adjusted GDP has more than kept up with debt growth, suggesting monetization of the U.S. debt. 

Now, the monetization impulse is hooking higher at a time when QT is slowing and the deficit is rising.

“The monetization impulse is currently accelerating, heralding days of potentially persistent inflation,” Tadesse says. The metric closely tracks the path of realized inflation, with its turning points leading inflation peaks and troughs by roughly six months. One useful upshot: Tadesse says real assets–including commodities, real estate and equities focused on natural resource-related investment–perform significantly better during accelerating monetary-impulse phases going back to the 1970s.

It makes sense that central bankers and investors would find relief in the latest round of inflation data. But in the context of growing budget deficits and central bank financing, cooler inflation numbers may prove little more than a temporary reprieve.