Post-midterm policy gridlock

Beyond the political implications of Tuesday’s midterm elections, these results will have material economic and fiscal implications - and with global spillovers.

Treasuries rallied on Wednesday partly on a market assessment that post-midterm policy gridlock will be positive for US fiscal outcomes, removing the potential for fiscal loosening. But this is unduly optimistic. Further tax cuts are off the table, but it is difficult to see material fiscal consolidation under this political configuration. And importantly, debt servicing costs are the key driver of the expanding fiscal deficit: these costs will continue to rise sharply in the absence of active policy decisions. In this context, gridlock is not an unambiguous positive.

In the absence of fiscal discipline, the fiscal/political imperative to reduce US government borrowing costs will increasingly drive decision-making. Recent US Treasury actions (JPY/USD intervention, shortening the maturity structure of government debt, and other forms of financial engineering) are designed to lower yields on Treasuries. Moves to lower rates through financial repression and coercive demands for foreign financing are increasingly likely.

Fiscal realities will also shape Fed decision-making. The Fed held the policy rate last week despite persistent above-target inflation. And Mr Warsh’s statements and decisions over the past several months suggest a focus on managing interest rates. Looking forward, expect policy rates to be contained to the extent possible in order to relieve pressure on government borrowing costs. Watch also for the Fed balance sheet to be used to buy government debt to drive down rates.

As I discuss in a client note this week, acute US fiscal exposure to rising interest rates will drive a range of unorthodox policy behaviours.