The Federal Reserve’s ability to tame America’s monetary bubble remains the biggest factor in the global economic outlook. The US central bank made an unexpected dovish turn at the latest Federal Open Market Committee meeting but has already had to walk some of that back.
The Fed is on schedule to trim its balance sheet by another US$1.1 trillion next year. There will, without doubt, be financial incidents and an erratic Fed would only make things worse. This could be the biggest threat to the global economy in 2024.
The US bond market nearly met with disaster in October. Surging bond yields raised doubts over whether the US government could continue to borrow trillions to fund itself. It could be that Washington did something special on the side to calm the market. Certainly, the episode demonstrated the increasing difficulty for the United States to tame inflation, maintain growth and ensure government funding.
The US government borrowed US$2 trillion from the public in the 2023 financial year. The Congressional Budget Office predicts a fiscal deficit of at least 6 per cent of GDP every year over the next 10 years. The expectation of declining interest rates will help the government to borrow enough to keep things running, which was probably the primary motivation behind the Fed’s change of tune.
The US market welcomed news of the Fed’s dovish stand. If the current bubble expands for a few months, inflation is sure to become a more serious issue. Rising paper wealth will lead to more spending. This is a constraint on what the Fed could say. It had to turn around and pour cold water on the market. The Fed needs to ensure the bubble is not too hot or too cold to maintain a stable and growing economy.
US Federal Reserve chairman Jerome Powell speaks during a news conference at the headquarters of the Fed in Washington on December 13. The US central bank seems likely to have reached the end of its interest-rate-raising cycle. Photo: Getty Images
The US is a bubble economy. The most revealing indicator of this is the rising ratio of paper wealth to GDP. The driving force of a macro bubble is always excessive money supply. The Fed’s balance sheet is a giveaway in that regard – it expanded it by about US$4 trillion, from about US$900 billion in 2008, to support the financial system during and after the 2008 financial crisis and added another US$4 trillion during the Covid-19 pandemic.
The second part was a mistake. The pandemic disrupted the supply side and monetary stimulus couldn’t do anything about the disruptions. Instead, it just added fuel to the bubble. The Fed has yet to correct this mistake. Its balance sheet has been trimmed by about US$1.2 trillion so far, but the cental bank’s balance sheet might never be normalised. Much of the monetary overhang will be absorbed by inflation.
It was bizarre for the Fed to signal that the inflation fight was over. A tight labour market, elevated food prices and rent, strong wage growth, spreading unionisation and low productivity all point to an inflation-prone economy. There were temporary factors, such as supply chain disruption and surging energy prices, fuelling high inflation beforehand.
A nice, parabolic inflation chart becomes visible as these factors fade. Some might conclude from this that the recent spell of inflation was just a fluke. If the Fed thought that was the case, it would cut interest rates aggressively. The market would then become white hot, followed by a violent burst, like in 2000 and 2008. The Fed is clearly not that foolish.
The world has experienced a massive monetary bubble on the yuan-US dollar peg. The US and China account for about 40 per cent of the global economy. The peg guarantees that the currency market cannot exert pressure on their monetary policy.
The large monetary expansion stoked a massive property bubble in China and a similar bubble in the US stock market. The Chinese bubble led to overinvestment and overcapacity while that in the US led to overconsumption. They were balanced in their excesses and remained stable.
China’s property bubble has been deflating for two years, while the US has kept its bubble going with massive fiscal deficits. A one-legged global economy isn’t a stable situation. If the US wants to carry on in this way, its fiscal deficit will become bigger and bigger. As a result, the US bond market will become the engine for the global economy. Would the world have the confidence to put all its money in this basket?
Low inflation, interest rate cuts and no recession in 2024? Not so fast
The current trend is bad for the US in the long term. The yuan-dollar peg is keeping the US currency overvalued as other currencies have to try to stay competitive against the yuan. A shrinking manufacturing sector and rising trade deficit are symptoms of an overvalued dollar. This is why, despite rising subsidies, US manufacturing is crumbling. The economy is becoming increasingly dependent on government deficit spending.
US bond yields have to be high to attract enough money to fund the government deficit. If people expect declining interest rates, they will be more willing to put money in the market. The Fed would want to engineer expectations of rate cuts, but not its actual realisation. How long could such a situation last? However long the world remains dumb to the fact, that’s to the Fed’s benefit. If people wake up, though, all bets would be off.
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