Tag: Tax Revenues

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David Woo: Prelude to volatility

The bond market had a heart attack last week. Rising inflation caused a massive back up in bond yields in the short end of the market. The market is now pricing in two rate hikes in 2022. The Fed will have to raise real interest rates in order to tame inflation.

Real interest rates are falling. The stock market is taking its cue from the bond market and is rising. Stock prices represent discounted future cash flows, so negative real interest rates make a big difference to earnings multiples.

The Democrats are determined to spend their way to a mid-term election victory, with a $1T infrastructure bill and $1.75T social spending, both light on tax revenue. The GOP will try to stop them when the debt ceiling issue returns in December but they don’t have much leverage.

Financial conditions will have to tighten a lot more in 2022. The Fed is way behind the curve and is going to have to play catch-up.

Conclusion

Inflationary pressures in the US economy are growing, while the Democrats plan a further $2.75T in fiscal stimulus which is light on tax revenues.

Long-term yields lag far behind inflation, with real interest rates growing increasingly negative. The assumption is that the Fed will tighten sharply in 2022 to curb inflation. We expect that the Fed will taper but is not going to rush to hike interest rates for three reasons:

  1. The Fed would be tightening into a slowing economy, with growth fading as stimulus winds down;
  2. High energy prices will also help to cool demand; and
  3. US federal debt levels — already > 120% of GDP and likely to grow further with proposed new stimulus measures — are a greater long-term threat than inflation. The Fed and Treasury are expected to work together to boost GDP and tax revenues through inflation, keeping real interest rates negative to alleviate the cost to Treasury of servicing the excessive debt burden.
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Modern Monetary Theory (MMT)

A reader asked me to explain MMT. I am not an economist and will try to avoid any jargon.

The basic tenet of MMT is that government has the power to reduce unemployment by increasing stimulus spending. Government spending in excess of tax revenues (a deficit) is funded by an increase in public debt. Deficits are likely to cause inflation but MMT holds that inflation can be reduced by raising tax revenues.

Problem with Lags

There is normally a lag between an increase in debt and the resulting increase in inflation. If you wait for inflation to rise before raising taxes, underlying inflationary pressures have already built and will be hard to contain.

There is also likely to be a lag between raising taxes and a resulting fall in inflation. This means that authorities will keep raising taxes for longer, causing an eventual contraction in employment.

The second problem is that it is far easier to increase government spending than it is to raise taxes. Voters seldom object to an increase in public spending but are likely to punish any government that increases taxes. This is likely to make the lag between identifying inflation and raising taxes even bigger.

Third, regular increases in government spending followed by tax increases (to subdue inflation) are likely to ratchet up government spending relative to GDP. Rising levels of public spending followed by rising taxes is simply creeping socialism and is likely to slow long-term economic growth.

Finally, sharp increases in public debt no longer deliver bang for buck.

Real GDP & Public Debt

Has inflation been tamed?

The consumer price index (CPI) is nowadays a lot less volatile than producer prices (PPI) which it tracked quite closely in the 1960s and 70s. Some of this can be attributed to better management at the Fed but the primary reason is the offshoring of manufacturing jobs to Asia.

CPI, PPI & Hourly Earnings

The service sector is largely immune from producer prices and fluctuations in offshore manufacturing costs are partially absorbed through a floating exchange rate.

We have witnessed a decline in global trade over the past two years and this is likely to develop into a long-term trend towards on-shoring key supply chains in both Europe and North America. On-shoring is likely to drive up prices.

Conclusion

Inflation is not dead. On-shoring of supply chains is likely to drive up prices. Rapid expansion of public debt is expected to weaken the Dollar, slow growth and fuel inflation. Long-term costs of bringing inflation under control are likely to outweigh the shorter-term benefits of MMT-level stimulus.

Notes

Hat tip to Neils Jensen at Absolute Return Partners and Luke Gromen at FFTT.

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