Fiscal Dominance

What the heck is it, and why does it matter?? - Article #6

I. Why is this a topic now?

First, a quick summary of The X Project’s Journey thus far. The first article simply introduced the mission and initial approach of The X Project, which will summarize the 10 most influential books read in 2022 (or prior), and the article listed those books.

The second article listed the 10 most influential books read in 2023 that will also be summarized. In an effort to further provide an understanding of who shapes the perspectives of The X Project, the article also listed 20 other (than the authors of the books) top influencers and the top 10 YouTube channels consumed.

The third, fourth, and fifth articles summarized the first three books on the first list in order of publication date. In the fifth and prior article, the book This Time is Different: Eight Centuries of Financial Folly was summarized. One of the primary conclusions is that there are consequences to too much government debt.

So, back to the question - why this topic now? Fiscal Dominance is a significant consequence of too much government debt, a condition the US has likely and recently started experiencing.

The other reason for this topic is that The X Project wants its growing subscriber base to experience how topics other than books will be presented and summarized, and this article will introduce an initial format and approach.

II. The X Project Guy’s Comments

Previously, The X Project Guy’s comments came towards the end of the article, but credit needs to be given upfront here to Luke Gromen for introducing the issue of Fiscal Dominance. Luke is the founder and president of FFTT, LLC, an independent research firm that provides insights on global macroeconomic, thematic, and sector trends. He has over 20 years of experience in the financial industry and is known for his ability to connect the dots between different data sources and perspectives. FFTT stands for the forest for the trees, and his other notable ability is to see the second and third-order derivatives beneath the surface. Luke is also a HUGE inspiration for The X Project.

I have been subscribing to FFTT’s weekly Tree Rings Report for a little over a year, and it was in the 6/2/23 issue that I first heard the term Fiscal Dominance. It was in the first section covering this article:

What's in US debt ceiling deal and who won? - 5/30/23, BBC News

After looking at a couple of perspectives on what the Treasury is likely to do after the debt ceiling is lifted regarding the TGA (the Treasury General Account, which can be thought of as the federal government’s checking account), Luke states this:

“In our view, the preceding raises some important contextual questions:

• Why would the US Treasury refill the TGA with T-Bills when yields at the long end of the curve are so much lower than T-Bills?

• Why is the Treasury already worried about illiquidity in the deepest, most liquid part of the “deepest, most liquid market in the world”?

The answer to both questions points to some version of “the US government’s borrowing needs are now too large relative to what the long end of the UST curve can absorb without dysfunctioning.”

Furthermore, if we take another step back, both questions above suggest that US fiscal dominance is now a reality.”

III. What is the definition of Fiscal Dominance?

According to the top search result after asking this question of Google:

“Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that "dominate" central bank intentions to keep inflation low.” This definition is taken from the paper titled Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements, published by Charles W. Calomiris, who is Henry Kaufman Professor of Financial Institutions Emeritus at Columbia Business School, and Dean of the Center for Economics, Politics and History at UATX and was posted on 10/2/23 on the Economic Research page of the Federal Reserve Bank of St. Louis’ website.

Looking for another definition and digging a bit deeper into the Google search results uncovers this:

“Fiscal dominance is an economic condition that occurs when a country’s debt and deficit levels are sufficiently high that monetary policy ceases to be an effective tool for controlling inflation.” Daniel J. Ford, CFA, CAIA, PRM, is the Managing Director & Oxford Investment Fellow at the Oxford Financial Group, and he provides this definition in his article Fiscal Dominance: What It Is, and Why You’re Going to Hear More About It published 8/11/23.

IV. What does it mean? Takeaway #1

Fiscal Dominance is covered extensively in several of Luke Gromen’s Tree Rings Reports after the term first surfaced. So, what does it mean? To start with the simplest and most basic definition in plain English, Fiscal Dominance is printing money to finance deficits, and that causes inflation.

V. What does it mean? Takeaway #2

How much inflation? Luke then goes deep into Calomiris’s fairly wonky paper, cited above, for the first definition of Fiscal Dominance. The most impactful implication of the US in fiscal dominance would imply significant inflation rates of at least 16% based on Calomiris’s calculations.

VI. What does it mean? Takeaway #3

In the 7/28/23 Tree Rings Report, Luke covers what he believes is the most important Fed economist commentary of 2023 (at that point in time), which came in March from John H. Welch, former Dallas Fed economist and former Managing and Chief Economist, LatAm, and Brazil for HSBC. Welch said that the US is likely already in fiscal dominance and arguably has been since at least September 2019, when the repo market experienced a sharp and unexpected rate spike. (This event will be covered by The X Project at some point soon within the context of strain and volatility within the US Treasury market.)

VII. What does it mean? Takeaway #4

The key takeaway from Luke Gromen is that Fiscal Dominance creates a binary decision point for the Fed and US Treasury. One choice is to stand aside and let the US banking system crash along with the US and global economies. He argues that the Fed and US Treasury have already taken actions multiple times in recent years, indicating they are not willing to allow that to happen (another topic for another article).

The other more likely - if not most certain - choice is to return to quantitative easing (QE) and introduce yield curve control (YCC). Doing so would be highly inflationary. The X Project will also cover QE, YCC, and Inflation (not necessarily in that order) in future articles.

VIII. What does it mean? Takeaway #5

Returning to Daniel Ford’s article that provided the second definition cited above for Fiscal Dominance, the following sentence after his definition is: “In fact, persistently high interest rates in an environment of perpetually large deficits actually risks exacerbating inflation.” This is not what we have come to know and expect.

Ford asks and answers the question of why the 2020s may differ from previous rate cycles. He presents a couple of charts to show the difference, clearly showing we are in uncharted territory.

First is a chart of the total amount of US government debt held by the public as a percentage of GDP by the Congressional Budget Office (CBO), which includes future projections:

Second in another CBO chart showing historical and projected US government deficits with net interest outlays as a percentage of GDP:

Ford concludes his answer to why the 2020s may differ from previous rate cycles by stating (emphasis added): “The saving grace thus far for the US has been the dollar’s role as the primary reserve currency of the world. However, recent geopolitical events suggest that the dollar’s reign may be set to gradually erode as major commodity-producing nations seek to establish trade in alternative currencies. Regardless, the external demand for US Treasurys is likely to be insufficient to fund the government, meaning monetized deficit spending will be with us for the foreseeable future.”

There is a lot to unpack there, and The X Project will address the dollar, its role as the primary reserve currency of the world (and the corresponding role of US Treasurys as the primary reserve asset for global central banks), recent geopolitical events, commodities, the rising trade in non-dollar currencies, and the supply and demand dynamics for US Treasurys in future articles.

IX. Why should you care?

Ford summarizes the answer to this question well: “History suggests that US investors are likely to experience persistently above-target inflation, more pronounced cycles of inflation and stagnation and higher currency volatility than we’ve become accustomed to. History also suggests that policymakers will attempt to assuage the problem by managing the yield curve, thus subjecting investors to negative real rates of interest, sometimes referred to as “financial repression.””

Most people generally understand that inflation is bad because it reduces the value of money and erodes the purchasing power of consumers and businesses. Inflation also increases the cost of living and makes it harder to save and invest for the future.

The X Project has inflation on the topics to cover in future articles, along with negative real rates. The X Project will also cover deflation and why a number of respected and influential economists are arguing that deflation is the bigger concern, especially in the short-run when the next recession arrives.

X. What should you do?

The X Project is not providing investment advice, and nothing stated herein should be construed as such. The X Project is simply sharing knowledge, information, and ideas for consideration.

The X Project will cover in future articles various investment themes from a mid-to-longer term horizon extending out 3-10 years, but here is a general summary of the current positioning and investment theses to which The X Project subscribes:

1. Overweight cash and short-term US T-bills for optionality, given expected volatility related to the remaining list below.

2. Bullish gold and gold miner equities

3. Bullish Bitcoin

4. Bullish oil and oil equities

5. Bullish natural gas and related equities

6. Bullish uranium and related equities

7. Bullish industrial commodities and related equities

8. Bullish agricultural commodities and related equities

9. Bullish industrial and especially electrical infrastructure equities

10. Bearish long-dated US and other Western sovereign bonds

Aside from considering the investment themes above, which should do well in a secularly inflationary environment, especially if and when QE and YCC become a reality, what else should you do? Help The X Project continue its mission.

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