Political Regime Change in Washington Pours Kerosene on an Inflation Fire

By: Justice Clark Litle

Jan 06, 2021 | News

On Dec. 17, we wrote to you with the following headline: “The Stars are Aligning for Inflation’s Grand Return — and Bitcoin’s Dominance as an Inflation Hedge.”

Bitcoin was trading around $23,000 at that time. A few weeks later, it is up more than 52% (pushing $35,000 as we write this note).

Perhaps needless to say, the TradeSmith Decoder portfolio had a spectacular finish to an already excellent year. We anticipate 2021 could be even better — because of that whole inflation thing.

On Dec. 17 we said:

So, yes. Inflation is coming. Big inflation. Expectations are the first factor. A falling U.S. dollar is the second factor. Rising commodity prices will be the third factor, an overly stimulated top half of the economy clamoring for supply-chain goods in short supply will be a fourth, real upward momentum in wages and labor costs a fifth, mushrooming deficits a sixth, on and on.

All of that remains true. And now we can add another Godzilla-sized inflation driver: Political regime change in Washington.

In the aftermath of the 2020 presidential election, it looked like America would have a divided government. Democrats would control the White House and the U.S. House of Representatives, and Republicans would maintain their hold on the U.S. Senate (with Mitch McConnell wielding the gavel).

That isn’t the forecast anymore. As of Jan. 20, U.S. Senator Chuck Schumer will likely get the gavel. Republicans seemingly have lost control of the Senate. If that happens, the Democrats will have unified legislative control in Washington, for the next two years at minimum.

What does this do to our inflation thesis? It pours kerosene on the fire. The implications of this political regime change in Washington — and that is what it amounts to — are almost breathtaking.

First, we’ll do a quick recap of what just happened.

For those who aren’t caught up on the firehose of political events, the state of Georgia held a special election on Jan.5. In that election, two U.S. Senate seats were up for grabs.

Because Georgia is historically a conservative state, Republicans were expected to win both seats. Instead, they may have lost them both.

In one of the two Georgia contests, Democratic candidate Raphael Warnock has already been declared the victor. Warnock will be the first African American to represent Georgia in the U.S. Senate.

In the other contest, Democratic candidate Jon Ossoff has a statewide lead of more than 17,000 votes as of this writing, with remaining ballots expected to lean heavily Democratic.

Neither Republican candidate has conceded as of now — but realistically speaking, it is over. Warnock has won and Ossoff’s odds of victory exceed 95%.

This means the U.S. Senate will be split 50-50, which in turn means the White House breaks the tie. By constitutional law, the U.S. Vice President is also President of the Senate. Vice President-elect Kamala Harris will thus cast the deciding vote in the event of a 50-50 split, and Democratic Sen. Chuck Schumer will replace Republican Mitch McConnell as majority leader.

Why is this development inflationary? Let us count the ways.

The biggest reason is because Democrats are aggressively pro-stimulus, and majority control of the U.S. Senate will allow them to authorize more stimulus through a process known as budget reconciliation.

Legislation passed by way of budget reconciliation — a process created in 1974 — cannot be filibustered. This means that, on many items relating to the budget and to spending (like stimulus), Republicans will not be able to block passage if the Democrats can get to 50 votes.

As we explained in our Nov. 2 primer on the difference between monetary policy and fiscal policy:

With fiscal policy, the government can simply hand out money, and let people spend it however they want. Alternatively, the government can use fiscal policy to buy things itself, injecting currency into the system through direct transactions with private-sector businesses.

Either way, the core of fiscal policy is not about lending or borrowing. It is about the “helicopter drop,” in the sense that the government goes out and drops money from helicopters on people.

That kind of “helicopter drop” spending power, if wielded with force, is about as inflationary as it gets.

As you ponder the implications of that, recall that Vice President-elect Harris, when she was still Sen. Harris, along with Senators Bernie Sanders and Ed Markey, introduced a bill in May 2020 proposing recurring payments of $2,000 per month to American households earning less than $120,000 per year.

And then reflect on the fact that, with political regime change in the U.S. Senate, Democrats will control all the committee chairs. We are likely to see Sen. Sanders in charge of the U.S. Senate Budget Committee.

Unified legislative control — encompassing the White House, the House of Representatives, and the U.S. Senate — also means Democrats will have an easier time getting major recovery initiatives passed, along the lines of the massive public works programs introduced by U.S. President Franklin Delano Roosevelt (FDR) in the 1930s.

Then, too, senate control means Democrats will not only control the committee chairs, but they will decide which bills are brought to the floor. That, too, will have a major impact, increasing the odds of significant legislative changes in areas relating to worker protections, minimum wage levels, and other pro-labor initiatives.

With a 50-50 split, the Democrats’ senate majority will be as narrow as it gets. For some of the Biden administration’s goals, they will still have to reach across the aisle for Republican support. But they won’t have to reach very far, and there are numerous Republican senators who will be willing to embrace a pro-infrastructure, pro-worker stance if designed in the right way.

To simplify what is going to happen next, think about this: The beating heart of the Biden administration agenda will be figuring out how to stimulate the bottom half of the economy, and how to get fiscal help to low-income Americans and blue-collar workers.

That agenda will be inflationary by design, in part because the Federal Reserve and the U.S. Treasury will want to generate a certain amount of “good” inflation on purpose.

Remember that policy makers are more afraid of deflation than a little bit of “good” inflation, because runaway deflation can lead to an economic death spiral akin to what we saw in the early 1930s. As a result of this mindset, the Fed and Treasury are likely to be comfortable targeting a “good” dose of inflation, in the realm of 2% to 3%.

The challenge, though, will be keeping “good” inflation from turning into galloping inflation as worker wages rise, labor costs rise, fiscal spending initiatives expand, and the pro-stimulus “helicopter drops” keep coming. 

The other big reason why political regime change is inflationary is because of what it will do to investor psychology and expectations.

Stock market investors, on the whole, are financially conservative as a group. As a general rule, investors like to see restrained spending, limited budgets, and low inflation.

This makes sense when you consider investors’ natural self-interest. The most favorable configuration for asset prices is arguably a combination of loose monetary policy and tight fiscal policy, meaning a central bank that keeps interest rates low and a government that doesn’t spend too much.

Because of their natural orientation, investors are likely to process political regime change in Washington, and the prospect of pro-labor, pro-spending Democratic control, as a kind of low-grade inflationary panic attack.

As a result of this, exploding deficit fears will intensify. Declining dollar fears will intensify. And a hunger for hard assets will intensify.

Those fears will be stoked by political language: Senate Republicans, having lost control of the legislature, will be shouting early and often about fiscal ruin.

And at the same time, the fiscal ruin narrative will be fed by the data. Deficits and debt loads really are likely to go vertical in the next few years, even as the Federal Reserve is forced to buy more and more of the U.S. Treasury market (because foreign buyers will be absent).

And efforts to stir up “good inflation” by stimulating the lower half the economy will actually work — showing up in the data, too — because when you put money directly into people’s hands, they spend it.

Policy judgements aside, we see historic levels of trading and investing opportunity in this development. The return of inflation, after an incredibly long absence, was already set to be a very big deal.

As a result of political regime change in Washington — and Democrats getting unified legislative control — all of the inflation drivers get stronger, even as psychological expectations (investors fearing inflation in advance) create a powerful tailwind for commodities and hard assets.

The stage now looks set for another wild — and wildly profitable — trading and investing year ahead.


Related Articles