Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Ignores the Budget Deficit's Record Surge
Transcript
- Lucas: So the Treasury just reported that the federal budget deficit in July hit its highest level since March of 2021, and the immediate reaction in some corners was, this is going to force the Fed to act. And I think that's completely backwards. Luna: Backwards how? Because you'd think a huge deficit means more government borrowing, more pressure on rates, maybe more inflation. Lucas: Right, that's the instinct. But look at what the Fed is actually watching right now. The fed funds rate is sitting at 3.63 percent, and they've held it flat for months. Their own projections show inflation cooling toward target, and the July jobs report, despite some noise, still showed unemployment dipping to 4.1 percent. Luna: So the deficit is just... background noise for them? Lucas: Mostly. The Fed's mandate is price stability and maximum employment, not balancing the budget. And honestly, if today's episode made sense of how the Fed thinks about fiscal policy, that's the kind of clarity we love to hear about. If it was worth a coffee to you, you can find us at buy me a coffee dot com slash fexingo. Luna: Yeah, it really helps keep this show ad-free. And it also supports the kind of deep dives we do on numbers like the deficit. Lucas: Exactly. So let's get into the actual numbers. The July deficit came in at its highest level since March 2021, and that's a big jump from the same month last year. But here's the thing — bond markets didn't panic. The ten-year Treasury yield actually ticked down over the past week, even with the deficit news. Luna: That seems counterintuitive. More supply of Treasuries should push yields up, right? Lucas: In a vacuum, yes. But the market is also looking at inflation expectations. The ten-year breakeven inflation rate, which is what the market thinks inflation will average over the next decade, is at 2.27 percent. That's up slightly from last week, but it's still near the Fed's 2 percent target. So the market isn't pricing in a runaway inflation scenario based on the deficit alone. Luna: So the deficit is a supply story, but inflation expectations are the demand story, and the demand side is still pretty tame. Lucas: Exactly. And that's why the Fed can afford to be patient. They care about inflation expectations more than they care about the Treasury's cash flow. If expectations stay anchored, a big deficit is mostly a slow-burn issue for interest costs, not a trigger for immediate policy moves. Luna: But doesn't the deficit eventually create inflation? Like, if the government keeps spending, doesn't that add to aggregate demand? Lucas: It can, but only if the economy is at full capacity. Right now, real GDP growth is running at about 1.5 percent annualized — that's down from over 2 percent earlier in the year. And the unemployment rate, while low at 4.1 percent, is still above what the Fed considers full employment. So there's slack in the economy. The deficit is filling a hole, not overheating anything. Luna: That's a key distinction. So the Fed sees the deficit as a fiscal issue, not a monetary one, at least for now. Lucas: Right. And that's why they're holding the fed funds rate steady at 3.63 percent. They're not reacting to the deficit. They're reacting to inflation data, like the July CPI which came in essentially flat, and to the broader trend of cooling price pressures. The core PCE index, which is their preferred gauge, is barely moving. Luna: So what would change their minds? If inflation expectations started to drift up noticeably? Lucas: That's the trigger. If the ten-year breakeven inflation rate started moving toward 2.5 percent or higher, and stayed there, the Fed would have to take that seriously. Because that would signal that the market doubts their commitment to price stability. But right now, at 2.27 percent, it's still within the range they've been comfortable with. Luna: So the deficit is a slow-moving problem, but the Fed is focused on the here and now. Lucas: Precisely. And there's another layer here — the Fed is also watching the yield curve. We talked about this a few weeks ago, but the curve is steepening, with the ten-year at 4.70 percent and the two-year at 4.36 percent. That's actually a sign that the market expects some growth down the line, not a recession. And a steepening curve can coexist with a big deficit without forcing the Fed's hand. Luna: But what about the cost of servicing that debt? Doesn't that eventually become a problem for the Treasury, and maybe for the Fed if it gets too big? Lucas: It's a real concern, but it's a slow-moving one. Interest costs are rising, but they're still manageable relative to GDP. The bigger risk is if deficits keep growing and the economy stays weak, then you could have a situation where fiscal policy is doing the heavy lifting, and that's not sustainable forever. But that's a conversation for Congress, not for the FOMC. Luna: So the Fed is basically saying, not my problem. Lucas: In a way, yes. Their job is to keep inflation expectations anchored, not to balance the budget. And as long as those expectations stay near 2 percent, they can afford to look the other way. The deficit is a fiscal issue, and the Fed is a monetary institution. They operate in different lanes. Luna: But what about the political pressure? I mean, with a record deficit, there's got to be some pressure on the Fed from politicians to keep rates low to make servicing the debt cheaper. Lucas: There is always political pressure. But the Fed has historically resisted that, precisely because their credibility depends on being independent. If they were seen as bowing to fiscal pressure, inflation expectations would probably rise, and that would be counterproductive. So they are very careful to emphasize that they only look at economic data, not political considerations. Luna: That makes sense. So the next time we see a headline about a huge deficit, we shouldn't automatically assume the Fed is going to react. Lucas: Exactly. The market reaction is what you should watch. If the ten-year Treasury yield and breakeven inflation rates stay stable, the Fed can stay on hold. But if those start moving due to deficit concerns, then you'll see the Fed pay attention. Until then, it's more of a slow-burn story for the economy. Luna: And the July jobs report, which showed unemployment dropping to 4.1 percent, that supports the Fed's patience, too, right? Lucas: Yes, and that's a key point. The labor market is still tight but not overheating. Nonfarm payrolls barely changed, but the unemployment rate fell, which suggests some workers are leaving the labor force. That's not a red flag for inflation. If anything, it means the Fed can wait longer before moving. Luna: So the bottom line is: the deficit is big, but it's not the Fed's problem. They're focused on inflation expectations, and those are still anchored. Lucas: Right. And that's the key takeaway. The next time you see a headline about a record deficit and wonder if the Fed will hike, remember what they're actually watching: the ten-year breakeven inflation rate, the core PCE index, and the overall path of inflation expectations. The deficit is a fiscal issue, and the Fed is a monetary institution. Luna: But what about the fact that the budget deficit surged to its highest level since March 2021? Wasn't that during the pandemic stimulus? Does that compare? Lucas: It's a different kind of deficit. In 2021, it was driven by massive stimulus checks and emergency spending. Now it's more from ongoing spending and interest costs. But the economic context is different, too — back then, the economy was just coming out of lockdowns, and inflation was about to take off. Now we're in a more mature expansion, and inflation has been cooling. So the same deficit number can have different implications. Luna: So context matters a lot when interpreting these numbers. Lucas: It always does. And that's why the Fed doesn't just look at the deficit in isolation. They look at it in the context of the whole economy. And right now, the economy is growing at a moderate pace, inflation is cooling, and the labor market is stable. That's a picture that allows them to stay patient. Luna: So if I'm an investor, should I care about the deficit at all? Lucas: You should care, but not in a knee-jerk way. The deficit can affect long-term interest rates, and that can affect bond prices and even stock valuations. But it's a slow-moving factor. What matters more is the trend in inflation expectations and how the Fed responds. So keep an eye on the ten-year breakeven rate and the Fed's commentary, rather than just the headline deficit number. Luna: That's a helpful way to think about it. So the deficit is a background risk, not a front and center driver. Lucas: Exactly. And that's the takeaway from today's episode. The Fed is watching inflation expectations, not the deficit. So until those expectations break higher, the deficit is just a story in the newspaper, not a reason to change your portfolio. Luna: And we'll be watching that ten-year breakeven rate like hawks. Lucas: We will. And if it starts moving, we'll bring you that conversation. Until then, keep your eyes on the data, not the headlines.