The CBO estimates of deficits exceeding $1 trillion as far as the eye can see at a time when the economy is at full employment should be another warning that a bear market in bonds is probably the most likely scenario for the foreseeable future. Whatever happened to countercyclical stabilization policies? We now have an accommodative Fed policy and a procyclical fiscal policy.
The minutes of the March FOMC meeting show that Fed officials are getting more concerned. Most members increased their growth projections after seeing the tax cuts and spending increases. In a telling sentence, they worried that predicting the eventual impact of these fiscal initiatives was difficult because there is little history of such a policy when economic resources were fully employed. Actually, there was one–the Johnson-Nixon period of Great Society spending along with wartime spending. The Fed, under Arthur Burns, accommodated that spending by being too slow to raise rates. The results were not friendly to the bond markets.
Inflation is, and will continue to be much lower now, but it is apparently starting to strengthen. Most FOMC members are now much more comfortable that inflation will soon be in the target range and, therefore, more comfortable with additional rate increases this year and next.
If they exist, the bond vigilantes have yet to react to an ill-timed procyclical shift in fiscal policy. If they are placated by signs of slower first-quarter growth, they should recall that we see this seasonal pattern almost every year. The consensus estimate of 2018 GDP growth near 3% implies faster growth during the rest of the year. That is when the effects of the tax cuts and increased spending will begin to emerge.
And, to finance those deficits, the Treasury will forced to add to an already very heavy pace of debt sales. Bids in the auctions last week were not very enthusiastic. They could become less so in the months ahead, unless yields become more attractive.