What Fiscal Dominance Means for Your Polycule

If you're anything like me, you have half a dozen girlfriends who themselves have half a dozen boyfriends forming one massive linked list. The hot button topic in the cuddle puddle these days is fiscal dominance, and to my girlfriends' dismay it's wholly unrelated to findom (although I do suspect the Board of Governors are getting their rocks off).

I don't recommend reading mainstream news, particularly financial journalism. If you have to, do it first thing in the morning so that the rest of your day can only get better. A few days ago this article in the FT caught my eye. This quote is a good gist of the dynamic playing out in markets currently:

In the US, analysts say the current disparity between short-term rates — which are largely shaped by central bank policy — and more market-driven long-term borrowing costs partly reflects concerns that monetary policy will be kept looser than would be necessary to contain consumer prices.

The key takeaway is that rates would not be high enough to rein in inflation. This is of particular note due to Powell's speech today, in which he said:

In the near term, risks to inflation are tilted to the upside, and risks to employment to the downside—a challenging situation. When our goals are in tension like this, our framework calls for us to balance both sides of our dual mandate.

Chances are we will see a 25 basis point cut (0.25%) and more to come depending on PCE, CPI, and other data in the short and medium term. The market loved this, as it should: a lower short term rate means easier borrowing and thus cheaper money.

So what does fiscal dominance have to do with this? Well, just like you, me, and Wall Street, lower interest rates means lower borrowing costs for the Treasury. Less interest has to be paid when interest rates are low (duh!) and as a result that money can be allocated to other areas of the budget, like reducing deficits. This is important because as it stands interest expense as a percent of GDP is 3.02%. That may not sound like a lot, but it's nearly 882 billion dollars.

If interest rates are kept artificially low, it exacerbates inflation, which over the past couple years has remained a bogeyman despite the Fed's best efforts. Knocking rates down will juice asset prices, because if your money is worth less every day, why not own equities, Bitcoin, gold, etc as stores of value?

I suspect the ramp up in asset prices combined with lower borrowing costs will cause inflation to rear its ugly head again. How severely it does, and how the Fed responds, will be interesting to witness - in the same way that watching somebody get stung by a bee is.

Anyway, if you didn't buy the dip I've got some hummus to share.