Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / How the Fed Reads the Budget Deficit Surge
Transcript
- Lucas: So the July budget deficit just hit its highest level since March 2021, and the Fed is basically shrugging. There's a reason for that, and it's not indifference. Luna: Highest level since 2021? That's a pretty big jump. What changed? Lucas: It's a combination of higher interest payments on the national debt and some timing shifts in tax receipts. But the headline number spooked a lot of people, especially with the ten-year Treasury sitting at 4.71 percent. The usual narrative is that big deficits push yields up, which makes the Fed's job harder. Yet the Fed seems to be looking through all of that. Luna: Why would they look through it? Isn't that exactly what they care about, long-term rates? Lucas: Right, but the Fed's mandate is price stability and maximum employment, not fiscal sustainability. The deficit affects those channels only indirectly, and the timing is fuzzy. So they pay attention, but they don't react to every monthly number. It's more about the trajectory and what it implies for inflation expectations. Luna: And what is the trajectory telling them now? Lucas: The ten-year breakeven inflation rate is at 2.28 percent, which is actually up slightly from the day before. That's pretty well anchored. If the deficit were causing investors to panic about long-run inflation, you'd expect that number to be moving more decisively. It's not. Luna: So the bond market isn't buying the doom narrative either. Lucas: Exactly. And that's the key point. The Fed watches the deficit because it can feed into long-term rates and affect financial conditions. But they care about the level of rates, not the reason behind them. If yields stay elevated because of supply, that's different from rising because of inflation expectations. The former is a fiscal story; the latter is a monetary one. Luna: Interesting. So when the deficit surges, the Fed might actually see it as a reason to be more cautious, not less. Because higher yields can do some of their tightening for them. Lucas: That's exactly right. And that's why you hear Fed officials talking about financial conditions. They're not just looking at the fed funds rate at 3.63 percent. They're looking at the whole complex of rates, spreads, equity valuations, mortgage rates. And if the deficit pushes long-term yields up, that's effectively a tightening in financial conditions. The Fed can hold steady and let the bond market do some of the work. Luna: So they're actually using the deficit as a tool without admitting it? Lucas: Well, they would never frame it that way in public, but the logic is sound. The Fed's interest on reserve balances is 3.65 percent, and the effective fed funds rate is 3.63 percent. They've been on hold for a while. And yet, the ten-year is at 4.71. That's a meaningful spread. It shows that the market is pricing in some term premium, and part of that is due to the deficit. Luna: Term premium. That's the compensation investors demand for holding long-term debt, right? Lucas: Yeah. And when the deficit balloons, the supply of Treasuries increases. Investors demand a higher yield to absorb all that extra supply. That's the term premium. And the Fed is okay with that, because it's a market-driven adjustment, not a policy error. They're not going to step in and start buying bonds just to suppress yields. That would be fiscal dominance, which they want to avoid. Luna: Fiscal dominance. That's a term I've heard but never fully understood. Lucas: It's when the central bank feels compelled to keep interest rates low because the government can't handle the cost of its debt. It's a loss of independence. And the Fed is hypersensitive to that accusation. So they'd rather let the bond market reflect the fiscal reality than risk being seen as monetizing the debt. Luna: That explains a lot. So the deficit is actually a constraint on the Fed's freedom to cut rates, even if inflation were to cool further. Lucas: Precisely. And that's the part that often gets missed in the headline reactions. The July deficit is a big number, but the Fed's response is more structural. They're watching the long-run path of debt to gdp, not the monthly tea leaves. Right now, nominal GDP is at 32.5 trillion, so the debt is still manageable relative to the size of the economy. But if the deficit persists and growth slows, that equation gets harder. Luna: Growth is already slowing, right? Real GDP growth was 1.5 percent annualized in the second quarter, down from 2.1 percent. Lucas: That's right. And that's why this episode is so timely. If growth is decelerating while the deficit is widening, the Fed has a delicate balance. They don't want to choke off the economy, but they also don't want to signal that they'll tolerate higher inflation just to ease the government's funding costs. Luna: So what would actually make the Fed change course? What would need to happen for them to start reacting to the deficit directly? Lucas: Probably a move in inflation expectations. If the ten-year breakeven started drifting above 2.5 or 3 percent, that would get their attention. Or if long-term yields spiked in a disorderly way, like a sudden jump of fifty basis points in a week. That would force them to address market functioning. But right now, the message is just that they're watching. Luna: That's a very careful answer. Do you think that's the right approach, or are they being too complacent? Lucas: I think there's a case for both. On one hand, the deficit is a real problem that needs to be addressed by fiscal policy, not monetary policy. On the other hand, the Fed can't just ignore the fact that the government is borrowing a lot. But at the same time, if they were to start reacting to the deficit, where would it end? They'd be second-guessing every budget decision, and that's not their job. Luna: So they're basically staying in their lane, but hoping the bond market sends the right signals to politicians. Lucas: Exactly. And that's the subtle balance. The Fed wants the bond market to discipline fiscal policy, but they don't want to be seen as the ones wielding the whip. They'd rather let the term premium do the talking. Luna: Yeah. You know, walking through this with you actually makes it clearer, not just the deficit but the whole Fed thinking. At least for me. Lucas: That's good to hear. And if today was actually useful to you, the way these stay ad-free is listener support. If you want to help keep this going, you can buy me a coffee at buy me a coffee dot com slash fexingo. No pressure, just helps keep the lights on. Luna: And we genuinely appreciate it. It keeps us independent and able to dig into these topics without any sponsor strings. Lucas: Alright, back to the deficit. So one more angle to consider: the composition of the deficit matters too. Not all borrowing is created equal. If the deficit is driven by infrastructure spending that boosts productivity, that's different from just funding consumption or interest payments. Right now, a big chunk is interest payments, which is kind of a dead-weight loss. Luna: So the quality of the deficit is deteriorating. Lucas: That's a fair way to put it. And that's something the Fed watches. Because if the deficit is just servicing past debt, it doesn't create future growth. So the long-run sustainability gets worse, and eventually that could feed into inflation expectations. But again, that's a slow burn, not a flashpoint. Luna: And what about the international angle? We saw that headline about Russia firing an economist, and the Iran war risks hitting G7 growth. Does the Fed care about foreign deficits? Lucas: They care about the spillover effects. If global growth slows, that can dampen demand for U.S. exports and affect inflation through commodity prices. But they don't directly target foreign deficits. They care about how those economies affect the U.S. outlook. And right now, the dollar's strength is also a factor. A strong dollar can keep inflation low by making imports cheaper, but it also pressures emerging markets. Luna: So it's a global balancing act. Lucas: It is. And that's why the Fed has to be so careful. They can't just react to one number. They have to weigh the deficit, inflation, growth, global risks, and financial conditions all at once. That's what makes their job so hard, and why they tend to err on the side of patience. Luna: Patience, but not complacency, as you said. Lucas: Right. And I think that's the takeaway. The deficit is a slow-moving variable that the Fed watches, but it's not going to trigger a pivot on its own. What would trigger a pivot is if inflation expectations become unanchored. And right now, they're not. Luna: So if I'm an investor, what should I look for in the coming months? Lucas: Watch the ten-year Treasury yield and the breakeven rate. If the ten-year starts pushing toward 5 percent, that's a signal that the market is losing confidence. And if breakevens start creeping up, that's a red flag for the Fed. But if those stay relatively stable, the conversation about the deficit is just background noise. Luna: That's a really useful framework. Thanks for breaking it down. Lucas: Glad to help. Now let's see what the data tells us next month.