Are liquidity and deflation risks emerging? One economist is worried
Investors are debating a number of scenarios. One is that Trump will install enough cronies on the board of the U.S. Federal Reserve that rates will be cut as many as five times in the next year. Supporters believe this could be incredibly bullish for markets, especially equities.
There is no reason to believe Trump won’t achieve that result. I personally believe he will get his way with the Fed. But whether the outcome is bullish depends on who you ask.
Trump’s attempted firing of Fed Governor Lisa Cook is the first-ever attempt to fire a Fed Governor, which, alongside his public berating of Chairman Powell, represents the clearest threat to the 111-year-old central bank’s independence since the Nixon administration.
And one cannot help but be reminded of Turkish President Recep Erdoğan, who strong-armed that country’s central bank, imposing his theories about fighting inflation with lower interest rates. Erdogan’s unconventional views led to spiralling inflation rates of 70-75 per cent in 2022, and eventually to the collapse of the Turkish lira.
I will let you decide whether Trump taking control of the Fed is bullish or bearish.
In a recent interview, economist Lacy Hunt, Executive Vice President at Hoisington Investment Management and a former senior economist at the Federal Reserve Bank of Dallas, addressed the issue of interest rates and whether they should be lowered. As an aside, I did a little research and discovered that Lacy Hunt was a senior economist at the Fed from 1969 to 1973. It looks like it was his first job out of university.
Drawing on the Great Depression, Hunt contends that U.S. fiscal policy is more restrictive than most think, with tariffs likely to trigger a deflationary spiral. He criticises the Federal Reserve for being way behind the curve and advocates for aggressive rate cuts to tackle emerging risks.
Fiscal policy is more restrictive than meets the eye
Hunt challenges the narrative of expansive fiscal stimulus. He describes current policy as “extremely restrictive,” citing the Congressional Budget Office’s (CBO) analysis of the “Big Beautiful Bill Act”. Over the next decade, it projects $US3.4 trillion in added spending – about $US340 billion annually– but this figure embeds $US3 trillion in “accounting tax cuts” (extensions of the 2017 rates with no net macroeconomic benefit) and another $US3 trillion in expenditure reductions. Net stimulus? Just $US400 billion over 10 years, or $US40 billion per year.
We note, as Hunt does, that S&P Global’s assessment is that the U.S. fiscal situation is “stable,” neither improving nor deteriorating, partly due to anticipated $US3 trillion in tariff revenues over the decade ($US300 billion annually). This could offset much of the stimulus, creating a near-balanced outlook. However, Hunt emphasises that tariffs aren’t a one-off event, but rather evolve through multiple rounds of retaliation, squeezing margins and reducing demand for price-elastic goods.
With U.S. goods imports at $US3.3 trillion last year and current tariffs around 10 per cent, Hunt estimates an initial $US330 billion annual hit – before dynamics kick in. Retaliation flattens prices while demand plummets (he estimates a price elasticity of 1:3, meaning a 1 per cent price hike cuts demand by 3 per cent). Consumers substitute, defer purchases, or forgo items altogether, resulting in a broader economic drag.
A deflationary threat
A central theme in his analysis is the risk of an “endogenous shock to liquidity” from tariffs, echoing Charles Kindleberger’s description in The World in Depression: 1929-1939. Tariffs initially raise prices, but retaliation and elastic demand cause volumes to fall, compressing corporate margins. Firms can’t pass costs on without losing market share, leading to reduced liquidity – an “endogenous” (internally generated) rather than exogenous (Fed-controlled) process.
Companies then cut production inputs such as labour, resources or capital, amplifying liquidity shocks. Improving the trade balance (current account) worsens the capital account, reducing foreign investment in U.S. assets. Foreigners hold approximately $18 trillion in U.S. equities, $5 trillion in corporate bonds, $2 trillion in government mortgages, and $8 trillion in Treasuries. Less inflow means tighter liquidity across markets.
Hunt likens this to the 1929-1939 era, where tariffs (e.g., the Smoot-Hawley Act) and central bank inaction fueled a “Kindleberger spiral.” [1] Today, he sees a “significant illiquidity process emerging,” deflationary in nature. Unlike the Great Depression, modern safeguards like unemployment insurance and bank deposits exist, but the process could still lead to severe downturns without intervention.
Behind the curve and data-blind
Hunt’s assessment is the Fed is “way behind the eight ball” and should cut rates by 100 basis points this year – more aggressively than the anticipated 25 basis points. Chair Jerome Powell focuses on first-round tariff effects (temporary price hikes), ignoring subsequent rounds that deflate prices and demand. Hunt rates the situation a “second or third alarm fire” with no visible smoke yet, urging pre-emptive action to avert the damage of a global tariff war.
Hunt’s criticisms extend to the Fed’s “data-dependent” approach. It’s worth remembering data is backward-looking and often requires adjustment. The Payroll surveys overstate strength (up 700,000 since January), while household surveys show a 600,000 drop. The difference produces a 1.3 million discrepancy. The Quarterly Census of Employment and Wages (QCEW) reveals massive overshoots, yet Powell calls labour markets “strong.” Response rates in surveys are falling, and models like birth-death adjustments are unreliable.
Weak growth, job risks, and AI-driven illusion
Hunt sees the U.S. hurtling toward recession, masked by flawed data. If he is right, then rate cuts would be an admission of a slowing economy and be bearish for equities.
First-half GDP grew 1.4 per cent annually, but excluding AI, Hunt suggests it may have declined or flatlined. Third-quarter indicators (July data) show real consumption up 1.3 per cent, but trade deficits subtract 0.45 per cent, and government spending has dipped. The net result could be growth of around 0.5-0.6 per cent.
Meanwhile, Hunt notes the labour market is deteriorating. He points to the growing discrepancy between the Bureau of Labor Statistics jobs report and the Quarterly Census of Employment and Wages (QCEW), the latter, which surveys millions more establishments, revealing declines in employment. Elsewhere, state-level data published by Danielle DiMartino Booth’s QI Research indicates June job losses of 65,000. If tariffs accelerate squeezes on margins, Hunt predicts firms will further shed labour in non-AI sectors.
Hunt also believes US growth is skewed with AI driving capex. Outside of AI Hunt believes growth is negative and the “averages” mask a bifurcated economy – AI booms, the rest contracts – raising recession risks where most jobs reside.
Mania, demographics, and command economies
An August 15 New York Times headline told readers, “The stock market is getting scary.” Economist Burton Malkiel pointed out that stock valuations are near the highest levels in 230 years, and warned, “there are worrisome signs that investor optimism may have gotten out of hand.”
Elsewhere, according to Bloomberg, portfolio managers at Morgan Stanley, Deutsche Bank, and Evercore are preparing clients for a possible 10-15 per cent drop in equities., while Goldman Sachs sees a “latent risk of unwinds” if anything upsets a fragile “Goldilocks” setup.
Hunt warns of a Kindleberger-style mania: Valuations at extremes, and the market cap-to-GDP ratio is at an all-time high. As we have noted here at the blog, forward price to earnings (P/Es) currently imply low single-digit S&P returns over the next decade, and the presence of Trump virtually ensures volatility. It is also worth noting that Meta is depreciating its AI chips over a 10-12 year period, even though Nvidia’s CEO claims the chips have a one-year life cycle. That means the hyperscalers may be overstating their earnings.
At this juncture it may be worth bringing up Jim Chanos, the famed short seller, who is concerned about the valuations of the AI hyperscalers. He likens the boom in A.I. chips and the valuations of the companies that make them and use them to the infrastructure companies that built out the internet in the late 1990s and early 2000s. A Chanos reckons an artifice is occurring that makes all AI-related companies look more profitable than they really are. He asks, how can Nvidia take the sales of these chips into its revenue and profits all at once, while Meta capitalises its costs for those same chips over 10-12 years. Chanos claims the mismatch of dollars, “disproportionately benefiting profits to a certain small number of companies”, adding, “In 1999 and 2000, it was the Ciscos and Nortels and Lucents. Today it’s Nvidia. So Nvidia gets to book revenues and profits. Meta and Microsoft and Amazon get to capitalise a lot of that spending.” And everyone’s profits look good.
Other ignored risks, according to Hunt, include disastrous demographics (the slowest U.S. population growth ever, and falling global birth rates, aging key economies) and shifts to “command and control” systems, eroding efficiency. According to Hunt’s estimates, growth falls by 0.1 per cent for every 1 per cent increase in government. He also noted U.S. real per capita growth has halved to 1.2 per cent since 2000. It was 2.3 per cent over the 100-year period between 1870 and 1970.
Hunt is admittedly “not very optimistic right now.”
Appendix
Lacy Harris Hunt is an internationally recognised American economist, known for his expertise in macroeconomics, debt cycles, deflation, and monetary policy. Hunt’s career spans several decades in both public and private sectors, beginning as a senior economist at the Federal Reserve Bank of Dallas from 1969 to 1973, where he also served on the Federal Reserve System Committee on Financial Analysis. He later held roles as vice president at Chase Econometrics, Chief U.S. Economist for HSBC Group, and Executive Vice President and Chief Economist at Fidelity Bank. Today, at Hoisington Investment Management Company (HIMCO) Hunt is the Chief Economist for the Wasatch Hoisington Treasury Bond Fund.
[1] The Kindleberger spiral is a chart created by economic historian Charles Kindleberger that visually depicts the month-by-month contraction of global trade between 1929 and 1933 during the Great Depression
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
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