Inflation in the Twenty-First Century: A Circular Flow No Longer
September 12, 2023·15 comments·In Brief
For two decades, a self-reinforcing cycle financed America's deficits: dollars paid for Chinese exports flowed back as Treasury purchases, providing cheap funding for government spending. That cycle has ended. China and other major exporters stopped buying bonds years ago, yet the U.S. government has only increased its borrowing. Something filled the gap, but that something is now trying to exit.
• Foreign central banks that once recycled dollars into Treasuries have shifted strategies. China began diversifying its reserve holdings after 2007 and accelerated the process by 2011. Oil and commodity exporters made the same calculation. The cumulative shift represents trillions of dollars no longer flowing into U.S. bonds.
• The math that made Treasury purchases attractive no longer holds. Yields have been too low relative to inflation for years. After the financial crisis, the opportunity cost of Treasuries versus other investments became untenable, and geopolitical risk (asset freezes, sanctions) made the position less secure. Countries stopped buying despite still accumulating dollars.
• The Federal Reserve became the replacement buyer, purchasing $4 trillion in Treasuries to absorb demand that evaporated elsewhere. Financial centers like London and the Cayman Islands picked up some of the flow, likely as proxies for the countries that stepped back. But the primary buyer was always the Fed, masking a structural problem.
• The current fiscal trajectory assumes rates will stabilize at 4%, a figure that only makes sense if inflation stays at 2%. If inflation runs at 3, 4, or higher, those yields become uncompetitive and the deficit picture becomes untenable. Higher rates would make the deficit mathematically catastrophic, yet lower yields won't attract the buyers the government now needs.
• The Fed faces pressure from two directions: it can't sell its holdings while Treasury issuance is accelerating, and no realistic private demand exists to replace what it's been doing. That leaves limited options for managing both inflation and deficits without using one as a tool to finance the other.
Subscribe Today to Read More
Unlock instant access to this and hundreds of other evergreen essays that explore the world of narrative through hard science and human wisdom.
- Make more informed decisions as an investor and citizen.
- See through the nudges of Big Politics and Big Media.
- Become a better consumer of news.
- Maintain your autonomy of mind in a swarm of narratives.
- Join a community of more than 100,000 truth-seekers.
Looking for Deeper Insights?
Unlock exclusive market intelligence, trade ideas, and member-only events tailored for investment professionals and active investors with Perscient Pro.
VISIT PRO
DISCLOSURES
This commentary is being provided to you as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. Epsilon Theory will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results.
Statements in this communication are forward-looking statements. The forward-looking statements and other views expressed herein are as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Epsilon Theory disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein. This information is neither an offer to sell nor a solicitation of any offer to buy any securities. This commentary has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Epsilon Theory recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives.
Comments
(Figure 2.3 didn’t load for me. Is it local to me?) Thx!
Loads OK for me on Brave.
If I may interject an ET concept into this discussion. “What do we need to be true”.
The federal fiscal trainwreck happens very quickly at elevated interest rates. My guess is inflation will come down to or below the FEDs 2% target as the BLS will change the formula and/or hedonically adjust the excess inflation away. They will introduce new “incentives” for banks, insurance companies and pensions to force them to become ever expansive buyers of treasuries.
The Renfields in the financial media will spread the good word , that will put off the reckoning another decade or so.
@Victor_K Can you see it here? It might be that your browser has some issues with WEBP images.
I can not see the imagine in Safari, but can in Chrome.
Clearly the USA keeps meddling with the laws of balance - moving the fulcrum, reshaping the fulcrum. But ultimately gravity rules here. I keep reading about supply of money from Treasury buyers and the changes in dynamics (one of which Kevin illustrated in this thread).
I guess my simple question: Is there enough supply in the world of money to sustain an ever increasing share (40% and rising) of the world’s deficits (USA) for a mere 4% (USA) of the world’s population? Doesn’t gravity come in at some point and reset things to a proper balance?
If the world has other alternatives, clearly rates in USA have to move up or stay higher, but who are the other buyers? Jack/Jill taxpayer, USA institutions, the FED? Doesn’t that supply shift start starving the private sector?
These scenarios certainly seem to have higher odds of playing out given the geopolitical shifting going on, at least that’s my read?
Thoughts?
That would be the playbook, it could be running out of pages. The commercial banks seeking to hold more short term treasuries will reduce the supply of credit to business; counterproductive if production and exports are hoped to reduce deficits.
I think the more useful comparison is debt and deficits as it compares to our GDP vs that of the world population. Your point still holds just not as striking.
Of course Govt borrowing crowds out the private sector. I just dont think our leaders look at world nearly the same as we do. I think they know it’s a house of cards They just ask themselves " How can we put off the collapse until WE are out of power. For current Democratic leadership. Biden , Pelosi, and Schumer that’s not very long. For GOP Trump , McConnel and McCarthy its not very long either —so maybe the bill will be paid sooner than expected.
Yes the GDP filter is very helpful (and indicator is better than i thought).
Odd enough, i just saw a post in a Mauldin publication where Kevin’s plumbing drawing is playing out with the saudi’s…their treasury holdings have fallen from $184B to 108B in…3 years. My hunch is that USD from USA is still flowing at a decent rate to Saudi for oil, especially in the last 3 years.
Hmm.
OK thanks all! Image loaded in Chrome but not in Safari. (I wonder how much other stuff I missed over the years?) Thx!
Continue the discussion at the Epsilon Theory Forum...