Fiscal Dominance and the Fed's Waning Influence: Gold's New Role

[00:00:00]So I think that any given FOMC meeting is not that relevant. So a 25 or 50 basis point change is not particularly relevant. Uh now if we start talking you know replacing a Fed chair and and other parts of the committee and getting like a 300 basis point cut or something like that. I mean that that starts to become meaningful. So magnitudes matter. Uh you know if we're running at 1 to 2% interest rates that's a different environment than than 400 uh basis points and change. Now, if you look at kind of the purpose of interest rates, like what the central bank's trying to do, you know, they're they're obviously their mandates are unemployment and inflation, but then the question is what are they hoping to do with interest rates? Why do why does that matter? Um, and what they're what the Fed mainly does is impacts bank lending. Uh, that's kind of the whole, you know, purpose of of the interest rates is is in theory higher interest rates would slow down bank lending uh by making borrowing more expensive. uh whereas uh cutting rates makes borrowing more attractive and you kind of restart the credit cycle. Uh now the problem is that when you're in fiscal dominance, bank lending is not the main source of new money creation.

[00:01:06]So for example, back in the 70s when um you know baby boomers were entering their home buying years, which is peak credit formation, we had the highest uh historical rate of bank lending in the country. And so the money creation was largely led by bank lending with some fiscal on top of it. Obviously you had the Vietnam war, you had great society programs, uh these were adding to it, but there was more money coming from bank lending. So when Vulkar jacks up interest rates, uh he did meaningfully slow down bank lending. And the problem is that this entire cycle uh starting before CO, during CO, after CO, none of this was really caused by excessive bank lending. It was all that really large fiscal stimulus that was monetized. Uh so the Fed is is trying to kind of slow down bank lending which is just not really the key thing here. Uh so their handful of industry changes don't make a huge difference in that sense. Uh where it shows up if they do a massive cut you probably get a weaker dollar. Uh you probably get a boom in emerging markets because they have all that dollar dominant debt that that gets relieved.

[00:02:09]Uh that can cause a you know kind of more demand for commodities in general including energy. uh which could be somewhat inflationary. Uh around the margins, they can restart lending to some extent. Um the challenging thing is that we see them talking as though short-term rates and long-term rates are the same thing, which they're not. So the Fed primarily controls short-term rates. And what we saw is that just because they trim short-term rates doesn't necessarily mean that like say mortgage rates go down.

[00:02:36]>> The bond market didn't buy it at all. I mean, we saw yields go up, right? So >> they didn't buy it. So it it it and now maybe if they let's say they cut 300 basis points they just completely kill the short end. Uh you know there's two outcomes that could happen. One is if if people are not getting interest rates on short-term paper anymore maybe they will bid for the longer end. They'll buy longeration treasuries and mortgages.

[00:02:56]Maybe they will drive those down to some extent. Or they could say well this Fed's not serious about inflation. Why would I want to own the long end of the curve and they could sell it off you? So there it's actually unclear how that would play out uh in in fiscal dominance. It wouldn't necessarily lower actual borrowing costs and and it well it didn't last time. Yeah. The the small sample we have so far this cycle is it didn't uh now whether a bigger one or a second one would I mean market conditions could change. If you have tariffs and the economy slows down then maybe you get a different result. I wouldn't want to uh fully say it wouldn't do it. Uh but they're just not the same thing is the point. uh the longer end is more set by the market, especially when the Fed's not actively buying and selling uh a ton of securities. If anything, right now they're they're they're trimming their longer end uh securities and mortgages.

[00:03:42]I think the Fed is less relevant. It's not irrelevant, but it's less relevant than probably the market thinks. The size of the fiscal deficits is more relevant. And the tariffs are more relevant. basically if you're going to if we're going to have, you know, 400 plus billion in new taxes this year, that's a bigger variable, I would say, than 50 or even 100 basis points from the Fed. You have to get into a lot bigger hikes or cuts to really start having an impact of of that scale.

[00:04:09]There's different types of yield curve control. I mean, during the the height of the pandemic, the lockdowns, uh, the Fed openly talked about yield curve control in their meeting minutes, uh, when they were kind of stabilizing the bond market. You know, they they dropped that. they didn't have to go that route.

[00:04:23]You know, right now we see kind of talk about politicization of interest rates.

[00:04:26]Uh that's not new. I mean, for example, in the in the prior uh administration, you had Elizabeth Warren uh she was on the Fed's case about trying to get rates down. Uh now we have the Trump administration on on the Fed's case trying to get the rates down. So everybody >> empowering she's still on it too, I think. So one thing they can agree on somehow.

[00:04:43]>> Yeah. They both want Yeah. Um and but I do think that as so one of the outcomes of fiscal dominance is you tend to get less separation between the government and the central bank uh because the the central bank whether they like it or not generally has to step in and put out fires. An example of that is when when the bank of England had the guilt crisis in 2022 uh so they announced a budget that had a bigger than expected deficit.

[00:05:08]They're not the reserve currency so they and they have a parliamentary system so they're a little bit more volatile with some things that happen. uh and basically their their guilt market sold off. They had uh leverage in the market that kind of resulted in more sell-offs.

[00:05:19]And so the Bank of England they actually it's kind of comical. They had so inflation there was like 10% of the time they they were going to start balance sheet reduction quantitative tightening and they had to cancel a a conference about balance sheet reduction to instead go and buy guilts uh to put out the fire. Now once they put out the fire then they eventually got to you know a period of quantitative tightening as they planned. Uh but the point is they had to like drop everything they were going to do and buy government bonds with with new kind of temporarily printed money to put out a fire. Um and that's that's generally what happens when you start to get more toward fiscal dominance. Uh and in in the US's case we have a situation where uh the Treasury has been more active uh in what they're doing. So uh you know people have called this like uh activist treasury uh and other uh things. It started under Yelen.

[00:06:09]so far it's continued uh under the current administration which is that they can do things like shorten the average duration of their debt. They can issue a higher percentage of their debt as T bills which is where there's more demand for it rather than term out their debt. They can refill their cash balance uh less quickly than they might otherwise would. Um they have different levers they can pull that are in some cases roughly equivalent to a a handful of of um industry cuts or a little bit of quantitative easing for example. Uh but basically you you get less independence. Uh the Fed, if you look at the New York Fed's like annual report uh on the state of their kind of securities book, they plan in roughly a year to go back to gradual balance sheet increases.

[00:06:52]Uh they probably wouldn't call it QB at the time unless there is a recession. Um but they'll they'll be ending their period of quantitative tightening and go back to gradual uh increases uh in that whether we get outright yield curve control. I mean that's a that's a very politicized thing to happen. Uh and it's also it's hard to do without a major acute crisis. So for example, when it was done in the 1940s, it was World War II. Uh so nobody was looking nobody was looking at treasuries. They're all looking at what's happening in the Pacific, what's happening with, you know, Europe. And everybody there was a a very kind of we're all in it together culture at the time. It was it was a very centralized culture in a way. um when you just we don't really have a reason. It's like well decades of kind of bad decisions have caught up to us is the answer. Uh and we just kind of gradually build up this really big debt burden with with interest rates that aren't going down anymore. Uh so we need to do yield curve control that gets really sloppy. So I think they're going to try to push it off, but I do think that there could be various kind of yield suppression techniques that keep it somewhat below what the market might otherwise settle at. I think the problem is that like I said before, when there's fiscal dominance happening, there's really no right answer by the Fed. If they cut interest rates too much, it causes problems. If they keep interest rates high, they're just blowing out the fiscal deficit more than if they had it low. So, they don't really, it's not bank lending that's the problem. Um, I think the best thing they could do is be transparent and just say, "Look, this is primarily a fiscal issue. uh we're we're going to try to make bank lending happen a moderate pace with the tools we have, which is what we're doing now. Uh but we don't really have good answers here.

[00:08:31]That's why I mean I would I would hate to be in that role.

[00:08:35]>> There's no amount of money you could pay me to want to even if I was even qualified to run the Fed. I I absolutely not. Um so until recently uh with stock market all-time high, Bitcoin all-time high, gold all-time high roughly uh and unemployment running uh within their target band of of low 4%. Um it's it's not really screaming we need cuts. Um uh now the the recent uh weakness in the job reports uh certainly increases the odds of a of a trim. The whole global economy is kind of sluggish. Energy prices are kind of low. um you have some degree of deceleration uh that is uh that argu for a cut. Uh I would also generally say tariffs like that's a different type of inflation than inflation from money supply growth.

[00:09:23]So they generally should look through tariffs per se. Uh just because that's that's that's more of a tax increase than a than a you know debasement driven price inflation. It's just a very different type of thing. Um, so I I do think they should look through that and mostly just think, you know, are are we controlling bank lending at the rate we're targeted to? Now, we can have a whole separate discussion. Should they should the Fed even set interest rates?

[00:09:46]>> Of course not.

[00:09:47]>> I'm in the camp that they shouldn't. But >> even exist. So, it's like if Yeah. If if they have this algorithm that they're supposed to roughly follow, which is keep unemployment, you know, as low as possible, keep uh long-term interest rates moderate, uh keep inflation in check. they're kind of in a position where there's no right answer right now.

[00:10:06]Uh but leaning somewhere toward moderately hawkish makes sense given the tools they have. I think we get an uptick in inflation. Part of it will depend on what happened with tariffs. I think what happened is you get a weaker dollar. Uh therefore you get a little bit of a boom in emerging markets and the mechanism for that is that they have dollar denominated debts. Uh and also they're trying not to have their currencies devalue relative to the dollar too quickly. So if the Fed's kind of hawkish, it forces a bunch of central banks around the emerging world to be somewhat hawkish. So if the Fed cuts, it allows a bunch of them to cut uh and therefore kind of multiple economies can get a little bit of a a lift uh which uh increases the demand for commodities including uh generally energy. Uh so you could get like another round of of energyled inflation um and just you know kind of higher commodity prices. Um, and so I think that that's the mechanism for how it would show up. Uh, I I wouldn't still necessarily expect like a 2022 level of inflation. Uh, because that was I mean we had like a 40% money supply growth in 2 years. Then we had of course the the shock in energy prices because of the war uh in Ukraine. Um, so absent some sort of huge energy shock um I wouldn't expect say 9 to 10% headline inflation and whatever you know true inflation was saying at the time. Uh I would expect lower than that but but probably above the the current