Dan Fuss
Vice Chairman
Loomis, Sayles & Company, L.P.
The Fed: Between Rock & Hard Place
It is hard to feel sorry for those who live in a marble palace but I do. Here’s why…
Looking forward in markets is difficult, to say the least. When I do this, there is an outline that guides the thinking. It is normally in four sections: Peace, People, Politics and Prosperity. These are each briefly covered below. Today, there is a new category: Central Banks.
Here we go… Peace, or lack thereof, is always the most important item. Normally this revolves around how much is spent for defense and what impact that has on the Federal Government balance and subsequent Treasury Borrowing Requirement.
Today, this is very important since there are a number of things happening around the world that call into question our continued moderation in defense spending as a percent of GNP. Net/net, we are proceeding on a basis that says that we will not have to step up defense spending over the next few years. A quick read of the front page of the newspaper indicates that assumption, which was quite valid a year ago, is now very tenuous. In view of the added geopolitical strain in the Middle-East, Eastern Europe and Asia, it does look like future defense spending will rise considerably. Hopefully, this is incorrect but now it seems to be the way things are going.
People, in short form, really covers two areas both of which are somewhat adverse. First is the change in the demographic proportions of our population and of populations around the world. Essentially, we are all getting older, on average. Second, in the advanced social democracies, the proportion of government spending that goes to support the older generations, as well as others in need, is rising. It is also rising as a percent of GNP. This brings us to the third label…
Politics! If both defense spending and “transfer payments” for social programs are rising, then we should have rising revenues to match them. That’s where the problem lies. It seems very difficult, in the U.S., to match the rise in spending with a rise in revenues since the best way to get revenues to go up is to raise taxes. This is definitely not a winning political program unless there is some crisis invoked event that is readily understood by all. Those rarely happen. The current geopolitical scene is scary but certainly not at the level that would cause a public outcry to raise taxes. Thus, it is reasonable to assume that Federal Government revenues will lag spending more than they have in recent years. That will result in a rising deficit. That results in a rising Treasury bond requirement. All other things being equal, that results in rising interest rates!
Prosperity is really shorthand for how does the economy do? As an increasing proportion of savings goes to finance the government, that certainly does tend to depress private sector activity. However, the government deficit can also be met by borrowing from others. That has happened in recent years as foreign central banks have been buyers of U.S. government debt in some magnitude. Also, in the last few years, our own Central Bank has been a good size buyer of our government debt. That is now scaling back to the point where it is nearly gone. So, unless we can encourage foreigners to buy our debt, it is quite likely that, all other things being equal, interest rates will rise to the point where they will start to buy our debt and so will we as individuals.
The conclusion of all of the above is that we are in for a period of time where U.S. dollar based interest rates rise. However, something new has been added. The role of the central banks, particularly of the largest ones, has evolved in an unofficial way. Because of the increase flows of capital around the world, particularly to the “emerging market”, global economic activity and political stability is more vulnerable to the flows of global capital. Because of that, the largest central banks have now been backed into an unofficial role (and this point is openly argued) of directly and indirectly providing liquidity to markets and economies in other parts of the world. The net/net of this, for the U.S., is that we now have an increased responsibility for the capital markets in other parts of the world, particularly during times of increased geopolitical stress. That’s where we’re at now. It makes it much tougher for the Fed to conduct monetary policy only with an eye on our domestic economy. The domestic situation is the Rock and the geopolitical is the Hard Place. How this plays out is anyone’s guess right now. My sense is that there will be a middle ground between the pressures for rising rates coming from the domestic side and the pressures for lower rates and expanded liquidity coming from the geopolitical side. That compromise will probably allow rates to go up somewhat in the U.S. but not to the degree we would normally anticipate with an economy growing more than twice as fast as our total population.
The next few years are going to be very interesting…
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