Navigating Fiscal Dominance in the Third Wave of Inflation
Welcome to Inflation III – Looks Like Fiscal Dominance
Many analysts and investors are comparing the current banking stress experienced in the United States, starting with SVB, to the 2008-9 financial crisis. However, these comparisons are misplaced since the root of the problem this time comes from duration losses on mainly long-dated US Treasury bonds due to increased interest rates as the US Federal Reserve tries to fight inflation. This article argues that the issue of US fiscal dominance, where potential bank losses push the central bank to loosen monetary policy, leading to higher inflation rates, needs addressing.
What Does Duration Mean?
Duration measures an asset’s maturity, in this case, bonds. It also measures the sensitivity of the price of a bind: the percentage change in the price of a spot due to a 100 basis-point shift in the market interest rate for that bond. For example, the US Treasury has a zero-risk rating, which means that banks do not need to hold reserves against them, but when interest rates rise, bond prices fall, as seen by banks’ current losses.
Implications for the Market
The market seems to think that the risk from US fiscal dominance, namely progressively higher inflation rates, is not a concern by expecting lower inflation and rates. The US Treasury market will remain volatile and continue the selloff trend. The issue’s severity is likely to cause turbulence, even though the overall leverage in the banking system is low. The Fed has again found itself at a crossroads, which is embarrassing since the solution to this problem is challenging and requires tighter fiscal policy.
- Unlike the current banking stress’s root, the 2008-9 financial crisis was the nonpayment of long-term loans due to overly-leveraged derivatives.
- The US Treasury and Fed’s guarantee of all bank deposits will increase moral hazard and return to “too-big-to-fail.”
- The United States’ current banking problem only impacts regional banks, not money center banks.
Inflation III looks more like fiscal dominance, whereby potential bank losses push the central bank to loosen monetary policy, leading to higher inflation rates. A tighter fiscal policy is needed for successful inflation-fighting in the long term. Though this current banking problem looks containable, whether the US Fed continues fighting inflation will prove crucial for Fed credibility in a short time.
In conclusion, the current banking stress in the United States should not be compared to the 2008-9 financial crisis. Due to increased interest rates meant to fight inflation, it stems from duration losses on mainly long-dated US Treasury bonds. The implications of US fiscal dominance have potential damages to banks and investors in fixed-income assets, with this issue being too embarrassing for the Fed to address quickly.