The Role of Monetary Interest Rate Policy vs Fiscal Policy in the Current Context

Last week was a week full of important macroeconomic events:

• Early in the week, BOJ officially ended nearly a decade of negative interest rates and is ready to turn a new page.

• Mid-week, the results of the Fed's policy meeting provided an optimistic forecast for economic growth, although with somewhat inconsistent policy direction from FOMC members (to be analyzed below).

• End of the week, the US House passed a government funding bill worth USD 1.2 trillion, just hours before the deadline to avoid a government shutdown.

For Viet Hustler readers, the impact of the BOJ's decision on the Japanese and global economy has been quite clear through last week's Macroeconomic article and mid-week market article.

Therefore, following last week's events, today's Macroeconomic column will focus on the Fed's interest rate direction (as well as Western central banks) at the present time; accompanied by the dilemma in balancing spending and revenue/borrowing of the US government. 

In which, monetary interest rate policy from the Fed and fiscal policy from the government, though separate, have a close relationship in regulating the US macroeconomy. Especially, the relationship between these two policy streams will become even more important if the Fed does not achieve the desired soft-landing.

FOMC: soft-landing expectations and warning of a high interest rate environment in the long term

The Fed's interest rate decision at the March FOMC was not surprising; what the market cares about is the Fed's policy direction.

And it seems the Fed chooses to extend the interest rate cutting process into the next 2 years:

• Fed still plans to cut interest rates 3 times (~ -75bps reduction) this year (year-end interest rate will fall to around ~4.6%).

• But interest rate expectations for 2025-2026 in last week's FOMC were higher than in December.

• However, from the dotplot, it can be seen that members' views on interest rates are inconsistent.

Economic forecasts, including GDP growth, unemployment, and inflation, are only reaffirming the trends we all observe.

Specifically:

• Fed increases forecast for GDP growth from 1.4% in December to 2.1%

• At the same time, also increasing year-end inflation expectations this year: Core PCE ~ +2.6% y/y  

• Labor market remains tight: (demand > supply) leading to expectations of Fed's unemployment this year remaining low 4% 

  • – consistent with expectations of persistent inflation due to the wage-price spiral effect.

Overall, the reversal of tight interest rate and monetary policy by Western central banks will certainly occur this year…

• Because policymakers anticipate the consequences of a credit crunch in the capital markets if interest rates are kept high for too long.

• Switzerland's SNB was the first central bank to cut interest rates in last week's meeting. 

  

• ECB may start cutting interest rates from this summer (June). 

• BOE and Fed may cut interest rates at the same time as ECB or 1-2 months later.

However, the pace of interest rate cuts will be much slower than the previous increases:

• Western central banks may start with small cuts, accompanied by periodic pause periods.

• Because the current extremely low unemployment rate (accompanied by high income levels) continues to drive strong spending growth - keeping inflation above the 2% target.

Of course, long-term interest rates will also rise - Fed's plan is to keep the long-term target rate at 2.5% - 2.6%.

• The West will likely not see negative interest rates (in Eurozone) or extremely low rates (in the US) as before and during Covid for a long time to come.

  

US Public Debt: Yellen and the government's battle to balance revenue and spending for society

The US House just passed a spending bill of USD 1.2 trillion - just hours before the government shutdown deadline…

• … of course, it also leads to a sharp increase in the fiscal deficit.

• In just the past 100 days, total US debt has increased by +USD 1,000 billion ~ average USD 10 billion/day.

• At the current rate, the US fiscal deficit for this fiscal year will exceed USD 3,000 billion ~ x2 the USD 1,600 billion projected by the US Congress.

• Total US debt is currently at a record USD 34,600 billion and could reach USD 35 trillion by June this year.

  

The US government's fiscal deficit and the pressure to issue more government debt partly stem from the burden of social security costs:

(The information below is excerpted from the article by Lance Roberts on realinvestmentadvice.com)

In 1935, when Roosevelt enacted the social security policy: 

• The average life expectancy of Americans was only ~60 years.

• The ratio of workers contributing to the fund / number of social security recipients was 42…

  (up to 42 workers contributing to pay social security benefits for 1 person)

  => The social security burden was not too severe…

But now:

• The average life expectancy in the US has risen to 79.25 => more elderly people receiving benefits.

  

• Meanwhile, there are only ~2 workers working and contributing to the fund to support 1 beneficiary (according to Peter G. Peterson Foundation)

  

• Declining birth rates also contribute to the future shortage of workers to contribute to social security funds to support the elderly

  

• More young people retiring early:

  

• The latest US Government Financial Report (February 2024): Social Security and Medicare funds are short by about USD 175 trillion.

  • USD 78.3 trillion are unfunded obligations that need to be paid out.

• While the actual investment returns of pension funds are much lower than their expected returns:

  

• Peter G. Peterson Foundation estimates that the Social Security Trust Funds will be depleted by 2035 - just 13 years away.

Therefore, perhaps Americans themselves have no reason to complain about the US Treasury continuing to borrow, causing cumulative debt to rise…

• simply because a large portion of government spending on social security for its own citizens still needs funding…

Hard-landing vs soft-landing: The role of Fed's interest rate-monetary policy vs fiscal policy from the government

Even though the fiscal deficit is increasing, the burden of social security costs (or defense spending and other government expenditures) can still be shouldered by the government at present…

• ... as the Fed is still achieving soft-landing thanks to the strong maintenance of consumer spending.

But what if there is no soft-landing? 

If the US enters a recession (unexpected drop in consumption), the Fed can influence capital markets through monetary policy. 

But implementing fiscal stimulus policies to boost consumption (through consumer relief packages, corporate tax cuts, infrastructure investment, increased public spending to boost GDP….) is the responsibility of the US government…

• A study by Fed San Francisco: during recessions where interest rates have reached the 0% limit (the limit of Liquidity Trap), the effect of fiscal policy is extremely important in stimulating economic growth…

  • At that time, even a small expansion of fiscal policy (expansionary multiplier below) will have a significant impact on boosting consumer demand growth…

  

And figuring out where to get the money to spend on the above fiscal stimulus measures will become Yellen's biggest headache right now…

And Viet Hustler believes that the possibility of “hard-landing” is still on the table…

• …. even though the recent FOMC showed the Fed is quite confident about the soft-landing possibility (traded off with sticky inflation!)

A quite logical point is that the “hard-landing” risk is still coming from credit-crunch in the financial markets due to prolonged tight interest rate-monetary policy:

Risks in the corporate debt market: 

• The default rate for high-yield bonds in the retail sector has surged unexpectedly this year - much higher than the historical average.

  • This only happens during recessions/crises - when consumption declines.

  

  • In the past few months, Express, Big Lots, 99 Cents Only and many retail companies are struggling to raise capital or restructure debt to address declining sales and skyrocketing costs. 

  • Joann Inc. also filed for Chapter 11 bankruptcy protection last week.

    

Although the default rate is increasing, the activity of “extending debt and pretending nothing happened” for high-risk loans (using leverage) is still continuing… under a fancy name “amend and extend (debt contracts)” (A&E: “amend and extend”).

• The amount of A&E debt in the past fiscal year has increased significantly - according to Barclays:

  

However, the market's risk-averse sentiment shows that investors are still aware of the risks in this debt restructuring activity:

• Issuers of risky bonds and leveraged loans have reduced the average tenor in their debt portfolios for 2024-2026 down to 40% (compared to last year) - according to BofA.

  • i.e. meaning they are issuing more short-term debt than long-term debt: 

  

• What could be the reason?

  • Because they don't want to lock in loans at high interest rates for a long time?

    This does not apply to junk bonds and leveraged debt - when they are willing to pay high yields as long as they can raise a lot of capital …

  • Therefore, for the most part (for junk bonds and leveraged loans), it is due to decreased demand from investors for their long-term bonds – due to fears of default risk next year…

Therefore, statistics from recent months about tightening financial market conditions easing… may not be entirely accurate.

Risks in the Commercial Real Estate (CRE) market:

• Expected, there will be about USD 929 billion in Commercial Real Estate (CRE) debt maturing this year (2014) + ~ USD 1,000 billion maturing in 2 years 2025-2026

  • Equivalent to 42% of total outstanding CRE debt will mature in less than 3 years.

  • In total, USD 3000 billion in CRE debt will mature from now until 2028.

  • Of which, the banking system is the main creditor for these CRE loans…

  

This year interest rates are expected to remain high, certainly CRE loans will face difficulties in extending debt.

• The risk of CRE defaults impacting financial institutions (especially small banks group - green color) is very large.

  

• Fact: Small commercial banks have nearly 70% of their assets in loans (their main activity), of which CRE accounts for the largest proportion.

  

In addition, a large amount of CRE debt is financed through Real Estate Mortgage-Backed Securities (Commercial mortgage-backed securities - CMBS) traded on the free market. 

• CMBS pools various types of real estate debt into a basket and issues them as securities on the market. 

  • While the quality (risk level, yields…) of the real estate loans in the basket varies - making it difficult for buyers of this type of security to assess the true risk level of CMBS.

  • Viet Hustler will have another article explaining the securitization activities of the banking system to turn real estate debts into securities and sell them on the free market.

  • In 2022, Bloomberg noted that the proportion of high-risk real estate loans added to CMBS baskets had increased to ~75%.

    

The CRE debt situation is no better in Europe. 

• Readers interested in the CRE debt market in Europe can refer to this article on Reuters.

Currently, real estate sector bonds are the bonds with the highest stress and risk globally.

Therefore, the risk of commercial real estate defaults could completely spread from small banks to other financial sectors and become systemic risk.

CONCLUSION

As analyzed above, in the FOMC meeting minutes from last week, the Fed is only reaffirming the economic situation we are seeing, including:

• Labor market still tight with Fed expectation that unemployment rate will remain low this year.

• Fed may achieve soft-landing with forecast of high economic growth (+2.1% y/y this year).

• But in exchange, inflation will remain persistent (sticky inflation) with core PCE projected to grow at +2.6% y/y this year.

• Fed still maintains the plan to cut interest rates 3 times as projected, but will slow down the rate cut process - extending this process over the next 2 years (2025-2026).

Powell's soft-landing dream is still there, but Yellen's dream of balanced revenues and expenditures is quite far-fetched: as social security spending continues to increase while revenues from contributions to social security or pension funds from workers are decreasing. At the current rate, the US fiscal deficit this fiscal year will nearly double the -USD 1.6 trillion deficit projected by the US Congress.

Perhaps the government is still managing the current burden of social welfare and defense spending. But if a true recession occurs, the government's fiscal space for stimulus policies to boost the economy will be limited due to the enormous debt level. During recessions, government relief packages play a more important role in driving spending growth compared to the Fed's interest rate-monetary policy, which supports various capital markets.

Of course, the Fed remains confident in the soft-landing outlook, but hard-landing cannot yet be ruled out. If the Fed holds current high interest rates longer, pressure on capital markets could erupt—sparking a new recession. The wall of maturing commercial real estate debt is flooding in 2024, carrying the risk of a systemic banking financial crisis.

Therefore, the Fed should remain vigilant about crisis risks in financial markets. Meanwhile, the US government should prepare its coffers for emergencies in case consumer spending suddenly plummets.