STOP LYING ABOUT INFLATION

The mainstream explanation of inflation is increasingly obsolete — and the bond market knows it.

There is something almost comical about the way economists continue to discuss inflation.

They argue about the Federal Reserve.

They argue about money supply.

They argue about deficits.

They argue about interest rates.

They publish models with impressive equations and then pretend that the economy will politely behave according to them.

Meanwhile, the bond market is sending a much simpler message:

The promises made by governments are becoming harder and harder to reconcile with reality.

That is the real inflation story.

And it is much more dangerous than the usual debate about whether the Fed should cut or raise rates.

THE MAINSTREAM IS WRONG — AND IT KNOWS IT

For decades, the dominant narrative has been remarkably convenient.

Central banks create money.

Money increases.

Demand increases.

Prices increase.

Central banks raise rates.

Demand falls.

Inflation disappears.

Beautiful.

Elegant.

And dangerously incomplete.

The real world does not work like that.

Inflation is not simply a monetary phenomenon.

It is not simply a fiscal phenomenon.

And it certainly cannot be reduced to a single variable in a textbook equation.

THE UNCOMFORTABLE PART

A government does not need to literally order its central bank to print money in order to create inflationary pressure.

It only needs to make promises that the economy cannot comfortably support.

Pensions.

Healthcare.

Defense.

Industrial policy.

Energy subsidies.

Tax cuts.

Infrastructure.

Social transfers.

Interest payments.

Every promise is politically attractive.

Every promise has a constituency.

Every promise becomes politically difficult to reverse.

And every promise eventually becomes somebody else’s liability.

This is the part economists prefer to hide behind equations.

The government cannot make everybody richer in real terms simply by issuing more claims on the future.

At some point, reality sends the bill.

THE BILL IS ALREADY ARRIVING

Look at the bond market.

The United States has accumulated an extraordinary amount of public debt.

At the same time, long-term government bond yields remain structurally higher than the ultra-low-rate world to which investors became accustomed after the financial crisis.

This matters.

Because government debt is not free money.

Every additional dollar of debt represents another claim on future government revenues, future economic growth, future taxation or the future purchasing power of the currency.

Eventually investors ask a very simple question:

What exactly backs all these promises?

And when that question becomes uncomfortable, yields rise.

THIS IS NOT JUST A MONETARY PROBLEM

Here is where I disagree with much of the conventional debate.

Inflation is not fundamentally about money.

It is not fundamentally about deficits.

And it is not fundamentally about interest rates.

Inflation is about the credibility of nominal claims against real resources.

That distinction matters.

A government can create financial claims almost indefinitely.

It cannot create oil.

It cannot create semiconductor engineers overnight.

It cannot create housing by issuing government securities.

It cannot create productivity with a press release.

It cannot create real wealth by refinancing yesterday’s liabilities with tomorrow’s liabilities.

Financial wealth and real wealth are not the same thing.

And eventually the market notices.

THE MOST DANGEROUS SENTENCE IN ECONOMICS

“There is no problem because the government can always issue more debt.”

This sentence should terrify you.

Because debt is not wealth.

A government bond is somebody’s asset.

But it is also somebody’s claim on future taxation, future government revenue, future inflation or future restructuring of the government’s balance sheet.

The bigger the stock of promises becomes, the more important the question becomes:

What backs them?

Not politically.

Economically.

FISCAL DOMINANCE DOES NOT REQUIRE A CONSPIRACY

People often imagine fiscal dominance as some dramatic scenario in which the Treasury calls the central bank and says:

“Print money or else.”

That’s cartoon economics.

Fiscal dominance can emerge without anyone explicitly ordering anything.

Imagine this:

Government debt rises.

Interest payments rise.

Deficits rise.

The Treasury needs to issue more debt.

Bond yields rise.

Interest costs rise again.

The central bank raises rates to fight inflation.

Debt-service costs increase even further.

Eventually monetary policy itself becomes a fiscal problem.

And suddenly the central bank discovers something unpleasant:

fighting inflation has become expensive for the government.

At that point, political pressure for lower rates becomes inevitable.

No conspiracy required.

No secret meeting required.

Just arithmetic.

AND THAT IS WHERE CENTRAL BANK INDEPENDENCE GETS TESTED

Central bank independence is one of the sacred principles of modern monetary economics.

It should be.

But independence is not magic.

A central bank cannot operate indefinitely in a vacuum while the government continuously expands its fiscal commitments.

Eventually somebody has to reconcile fiscal reality with monetary reality.

The question is not whether coordination exists.

It already exists.

The question is whether that coordination is explicit or hidden.

THE TREASURY AND THE CENTRAL BANK ARE ENTERING THE SAME BATTLEFIELD

When governments increasingly intervene to influence the cost, liquidity and maturity structure of their own debt, the distinction between monetary policy and debt management becomes much less clean.

Perhaps every individual operation is technically justified.

Perhaps every intervention can be defended as ordinary market management.

But the bigger picture matters.

If governments increasingly need to influence the conditions under which their own debt is financed, the bond market becomes political.

And once the bond market becomes political, the entire monetary framework becomes more fragile.

THE BOND MARKET IS THE REAL CENTRAL BANK

Here is my more controversial proposition:

The most important central bank in the world may not be the Federal Reserve.

It may be the market for government debt.

The Fed can announce whatever policy it wants.

The Treasury can announce whatever borrowing strategy it wants.

Politicians can promise whatever voters want to hear.

But if investors demand a materially higher real return to hold government debt, the entire economic system adjusts.

Mortgages adjust.

Corporate borrowing adjusts.

Equity valuations adjust.

Government interest costs adjust.

Currency expectations adjust.

And eventually fiscal policy adjusts.

The bond market doesn’t need a vote.

It simply reprices risk.

AND THAT IS WHY INFLATION IS POLITICAL

Inflation is often described as a macroeconomic phenomenon.

That description is incomplete.

Inflation is also a distributional mechanism.

Someone loses.

Someone wins.

Debtors can benefit.

Creditors can lose.

Asset owners may benefit.

Cash holders lose purchasing power.

Governments can reduce the real burden of nominal liabilities.

Workers may demand higher wages.

Companies may protect margins.

Retirees living on fixed incomes can be squeezed.

Inflation is therefore not merely a statistic.

It is a political battle over who absorbs the adjustment.

THE GREAT LIE OF MODERN FISCAL POLICY

The great lie is not that governments borrow too much.

The great lie is that governments can indefinitely promise more real resources than the economy can produce.

That is impossible.

You can finance the promise with taxation.

You can finance it with debt.

You can finance it through financial repression.

You can partially finance it through inflation.

You can attempt to finance it through productivity growth.

But you cannot eliminate the constraint.

Real resources are finite.

That is the constraint no central banker can repeal.

WHY THE CURRENT MOMENT IS DIFFERENT

The current environment is particularly dangerous because the fiscal problem is arriving at the same time as geopolitical fragmentation, energy shocks, industrial policy and enormous investment requirements.

Global bond markets are increasingly sensitive to fiscal sustainability, inflation and the enormous supply of sovereign debt.

At the same time, inflation remains a political problem because bringing it decisively back to target can require interest rates and economic conditions that governments may find increasingly difficult to tolerate.

This creates a horrible policy combination:

high debt + high interest costs + persistent inflation + political pressure for lower rates.

That is precisely the environment in which fiscal dominance becomes a serious possibility.

SO STOP ASKING WHETHER THE FED WILL CUT RATES

That is the wrong question.

Ask instead:

What happens if the government cannot politically tolerate the interest rate required by the bond market?

That is the question nobody wants to answer.

Because there are only a few possibilities.

Cut spending.

Raise taxes.

Grow faster.

Accept higher interest costs.

Allow inflation to reduce the real value of liabilities.

Or attempt some combination of all of them.

There is no secret sixth option.

THE NEXT INFLATION DEBATE WILL BE UGLIER

The next great macroeconomic argument will not simply be:

Monetarists vs. Keynesians.

It will not even be:

Fiscal vs. monetary policy.

It will be about something much more fundamental:

Can modern democratic governments continue making promises that the private economy is increasingly unwilling to finance at low real interest rates?

If the answer is no, the adjustment will come through prices, yields, taxes, spending cuts, currency depreciation, financial repression — or some combination of all of them.

And markets will decide the timing.

Not politicians.

Not economists.

Not social media.

Markets.

MY CONTRARIAN CONCLUSION

The central mistake in the inflation debate is to search for a single villain.

The Fed is not the entire story.

The Treasury is not the entire story.

Deficits are not the entire story.

Money is not the entire story.

The real problem is deeper.

Modern political systems have accumulated too many promises.

Debt is simply the financial record of those promises.

Inflation is one possible mechanism through which the system attempts to reconcile them.

Bond yields are another.

Taxes are another.

Austerity is another.

Currency depreciation is another.

Financial repression is another.

The accounting can be postponed.

The economics cannot.

And that is why the current debate about inflation is so dishonest.

We keep arguing about whether monetary policy is too tight or too loose.

We keep arguing about whether governments should spend more or less.

We keep pretending that the system can continue indefinitely.

It cannot.

The bond market knows it.

And eventually everyone else will.

THE QUESTION THAT MATTERS

Forget the next CPI print.

Forget the next central-bank meeting.

Forget the next political speech.

Watch the long end of the yield curve.

Watch real yields.

Watch inflation expectations.

Watch the currency.

Watch the government’s financing strategy.

Watch whether governments begin to interfere more aggressively with bond markets.

Because if the market begins demanding a permanently higher price for government promises, the world will discover something politicians have spent decades avoiding:

There is no such thing as free fiscal policy.

Someone always pays.

And when governments refuse to choose who pays —

INFLATION CHOOSES FOR THEM.

Roberto Balbino — CEO, Fintech SBB
Over 30 years of experience in finance, financial markets and international business.
Independent analyst of finance, economics, geopolitics and global markets.

Tags: Inflation · Public Debt · Fiscal Dominance · Federal Reserve · Treasury Market · Monetary Policy · Fiscal Policy · Macroeconomics · Sovereign Debt · Bond Markets