In economic news, the NY Fed SCE showed: “Median inflation expectations were unchanged at 3.0 percent at the one-year-ahead horizon, increased to 3.0 percent from 2.6 percent at the three-year-ahead horizon, and declined to 2.7 percent from 2.9 percent at the five-year-ahead horizon.” The survey also showed an increase in inflation uncertainty. The rise of inflation expectations at the 3 year horizon doesn’t seem like something welcome by the Fed. U.S. yields continued to climb and tech stocks got little reprieve from some of the recent selling.
While I move away from the discussion on valuations, in the first XTOD there is a link to an article titled 'Mega Cap World Domination' by Ben Carlson, that looks at some of what we’ve been discussing over the last week. His answer to the current investment debate or what he calls, conundrum, is “I own index funds and I diversify. Index funds will own the winners without having to pick them in advance. And diversification gives you the optionality to own the winners that often come from unexpected places.”
Today what we’ll touch on will combine two of the other major 2025 themes, one being fiscal policy and the other being “r-Star”. So it’s fitting to discuss “Fiscal r-star”, an idea coined by Marijn Bolhuis, an economist at the IMF, recently discussed on David Beckworth’s podcast Macro Musings. I mean who doesn’t need more largely unquantifiable “stars” to try to track?
So what is “fiscal r-star”? It is the real interest rate that stabilizes a country's debt-to-GDP ratio when output is growing at potential and inflation is at target, given a path of primary deficits or surpluses set by the fiscal authority. This is distinct from the traditional concept of monetary r-star, which is the real interest rate that stabilizes inflation and maximizes sustainable employment. Fiscal r-star can be thought of as the ceiling for real interest rates. If real interest rates rise above this ceiling, the debt-to-GDP ratio could increase rapidly (does this idea that higher interest rates can increase debt-to-GDP sound familiar to anyone??)
When you consider that the Fed’s liabilities are ultimately backed by the Federal Government and you look at things from a consolidated balance sheet perspective, Bohuis’ work highlights the tensions between fiscal and monetary policy. If fiscal policy is passive (meaning that fiscal authorities adjust spending and taxes to stabilize debt levels), then fiscal and monetary r-star will be the same. However, if fiscal policy is active and not responding to debt levels, the two can diverge. Under this framework a situation that could occur is that monetary r-star (the real rate needed to keep inflation in check) can exceed fiscal r-star (a lower rate needed to keep debt-to-gdp in check) which creates a tension that needs to be resolved.
So how might such a tense situation be resolved? Well, a few ways pop out. One is that the fiscal house gets itself in order by reducing spending, creating growth or otherwise raising revenue. Other resolutions could be steps taken by the Fed toward keeping rates lower at the expense of allowing higher inflation or other regimes of financial repression. All said the possibility that the U.S. may currently find itself in a situation where this “tension” exists is potentially concerning. Bolhuis also mentions that these larger fiscal-monetary gaps can increase the risks of an economic crisis.
Because of the risk that the Central Bank could keep rates low to accommodate fiscal authorities in times of tension, Bolhuis believes it is wise to maintain central bank independence. Perhaps subscribing to my favorite definition of central bank independence helps prevent a fiscal-monetary r-star gap. That definition is by Peter Stella and reads: “I define central bank independence in one sentence, it's the ability to raise interest rates when the Treasury doesn't want you to. And the Treasury almost never wants you to, because of the cost of the debt.”
All of this still seems to leave open a core dilemma of sorts. The central bank is tasked with maintaining price stability, which typically involves raising interest rates to cool an overheating economy. However, if fiscal policy remains expansionary despite rising interest rates, it can create a vicious cycle. Higher rates increase the cost of government borrowing, leading to larger deficits and potentially even more borrowing, which could further fuel inflation. This sounds very much like the Fiscal Theory of the Price Level to me. During Carter’s funeral last week, I mentioned Volcker. Stories from the Volcker era indicate that politicians took seriously the size and cost of financing budget deficits and clearly Volcker operated independently, essentially urging fiscal authorities to get their act together.
If I had one takeaway from this work on “fiscal r-star” is that it highlights what appears to be somewhat of an inherent truth that to achieve the “best” macroeconomic outcomes there needs to be some level of coordination between the fiscal and monetary authority in working towards their objectives, or at least some explicit acknowledgment of the trade-offs. Perhaps this paper highlights something John Cochrane often states (see this post from September) : “almost all current theories mix a fiscal tightening with a rise in interest rates. The rise in interest rates by itself has essentially no power to lower inflation.”
You should obviously form your opinion on whether the concept of “fiscal r-star” and “fiscal-monetary gap” are valid and useful concepts and from there what implications there might be for investors if you reach an opinion that the U.S. is at risk due to such a fiscal-monetary gap. Lastly, keep in mind this is different from “fiscal dominance” which is the idea that when government borrowings get so large the central bank is forced to keep rates low to accommodate those deficits and is something of the outcome after the fiscal-monetary gap crosses some tipping point.
XTOD: What's the more likely scenario? 1. We have an AI bubble that turns into a bust (even if AI tech is huge in the long run) or 2. Mega cap world domination rolls on I have some thoughts: https://awealthofcommonsense.com/2025/01/mega-cap-world-domination/
XTOD: Why it’s still early for crypto: We polled advisors across the country, and only 35% said they are able to buy crypto in client accounts today. Worth noting: Advisors manage roughly half of all wealth in America. There’s still a lot of room to run.
XTOD: As long as Marc Andreessen keeps promoting a16z's crypto vaporware, he doesn't belong anywhere near the levers of power. Ditto for crypto grifters like David Sacks and Howard Lutnick. There's no excusing their behavior.
XTOD: Private equity is “leveraged micro-caps with lockups and high fees” and private credit is “high-interest-rate loans that banks wouldn’t touch.” [Rasmussen] warns advisors not to let the “smoothed returns and laundered volatility trick you into thinking these aren't high-risk, high-fee assets with a lot of blow-up potential.” https://fa-mag.com/news/2025-may-be-a-whole-new-world-for-alternative-assets-80954.html
XTOD: Stan gave me this advice before my 1st born 15+ yrs ago.Best parenting advice I got. TIME is all we have. Minimize regrets
XTOD: Habits that have a high rate of return in life:
- sleeping 8+ hours each day
- lifting weights 3x week
- going for a walk each day
- saving at least 10 percent of your income
- reading every day
- drinking more water and less of everything else
- leaving your phone in another room while you work
https://x.com/awealthofcs/status/1878822696618021183
https://x.com/BitwiseInvest/status/1878885763418652976
https://x.com/ParrotCapital/status/1878884743447756960
https://x.com/wolfejosh/status/1878885089784008975
https://x.com/JamesClear/status/1878890125306011971
No comments:
Post a Comment