Higher Domestic Prices |
US consumers will also likely pay higher prices to domestic producers who would be uncompetitive without the tariffs. |
Recession |
A trade war would likely cause a recession, pushing the Fed to cut rates while falling tax receipts would increase the fiscal deficit. A recession would initially ease inflation, but increased deficits and stimulatory measures by the Fed would likely increase inflationary pressure over time. |
Fiscal Dominance |
The dollar is weakening as its status as the global reserve currency diminishes, as evidenced by the soaring gold price. |
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Foreign purchases of US Treasuries are declining as a percentage of GDP, which has increased upward pressure on yields. |
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The Fed will likely attempt to suppress long-term rates by opening up new sources of demand for Treasuries. While further Treasury purchases (QE) by the Fed are unlikely, they may attempt to achieve a similar result by relaxing the supplementary leverage requirement for Treasuries. With no SLR constraint, commercial banks can leverage Treasury purchases to infinity. This would make UST an attractive investment for commercial banks and has been done before, in 2008, to boost commercial bank support for Treasury markets. |
"We might actually pull treasury bill yields down by 30 to 70 basis points. Every basis point is a billion dollars a year." ~ Treasury Secretary, Scott Bessent |
After the Silicon Valley Bank (SVB) debacle, commercial bank demand will likely focus on T-bills without much impact on the long end of the yield curve. Bank purchases will effectively swap bank reserves at the Fed for T-bills to be held on their balance sheets, cutting out the Fed as the middleman. With QE, the Fed typically pays for Treasuries purchased by crediting banks with increased reserves, which are a liability of the Fed, and holding the securities as an asset on their balance sheet. This does not expand the money supply and is not in itself inflationary. However, increased reliance on the Fed and commercial banks to fund the government increases the risk of fiscal dominance. |
Fiscal dominance is when a country's debt and deficit are so high that monetary policy focuses on keeping the government solvent instead of controlling inflation. ~Simplicable |
Inflation: A Soft Default |
The $36 trillion in US federal debt is too large to be repaid. |
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Debt reduction would require reversing the current fiscal deficits of $1.5 to $2.0 trillion to a surplus of at least $1.0 trillion. The shock to the economy would cause a decades-long recession similar to the UK after WWII. Treasury Secretary Scott Bessent on reducing the deficit: |
"I was with one of the congressional budget committees two weeks ago, and they really want to cut this fast. And I said, you do realize every 300 billion we cut is about a percentage GDP, so you, we are trying to land the plane." |
Long-term austerity is most unlikely, and the only viable alternative is to inflate the debt away, boosting nominal GDP to the point that the debt ratio to GDP declines to about half its current level. |
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Conclusion |
China and the EU, the US's two biggest trading partners, will likely retaliate if it increases import tariffs. They will also likely withdraw investments from US financial markets over time. This is expected to drive up inflation and long-term interest rates, leaving the Fed with a stark choice. Fiscal dominance means that the solvency of the Treasury is likely to be prioritized over inflation. Especially after May 2026, when the current Fed chair's term ends, he will likely be replaced with a more pliant Trump appointment. Inflation is inevitable. Buy gold and defensive stocks on reasonable earnings multiples. Avoid high-multiple growth stocks and long-term Treasuries. |
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