'Drunken sailor'-like government spending could reignite inflation, analysts warn

A surge in government spending could throw a wrench into the Fed's plans to bring inflation back to target, according to economic experts.

In its most recent update, the Congressional Budget Office raised its deficit projection for this fiscal year to $1.9 trillion—up from its $1.5 trillion forecast from just a few months ago.

Behind the $400 billion jump are aid packages for Israel and Ukraine, as well as increased spending for Biden's student debt relief programs and Medicaid.

Ajay Rajadhyaksha, global chair of research at Barclays, didn't mince words in his analysis. "We are spending money as a country like a drunken sailor on shore for the weekend," he said.

Meanwhile, President Joe Biden and Donald Trump have not announced any plans or intentions to balance the budget.

We could see another ‘September 2019 moment’

According to JPMorgan analyst Jay Barry, the U.S. government will need to borrow $150 billion more by September to pay its bills.

He expects the government will get most of this money by selling short-term Treasury bills, a type of government loan that must be paid back within a few years.

If this happens, the total amount of these short-term loans could reach $6.2 trillion by the end of the year. That's a record high, up from $5.7 trillion at the end of last year.

“It is likely that the share of Treasury bills as a share of total debt increases, which opens up the question of who is going to buy them,” said Torsten Slok, chief economist at Apollo. “This absolutely could strain funding markets.”

With so many Treasury bills flooding the market, demand could be stretched thin. As a result, the government might need to offer higher interest rates to make these Treasury bills more attractive to buyers.

If that happens, Rajadhyaksha warns that the U.S. could have another “September 2019 moment,” otherwise known as the repo crisis.

The last time that happened, a lack of buyers in the short-term financing market drove interest rates for Treasuries above 10%, and the Fed was forced to intervene.

The Fed may be torn in two directions

JPMorgan’s Barry is concerned a supply-demand mismatch in Treasuries could force the Fed to fight on two fronts: keeping a lid on inflation and stabilizing short-term lending markets.

"The risk is quantitative tightening is going to have to end sooner than expected," warns JPMorgan analyst Jay Barry

A key tool in the fight against inflation is the Fed’s efforts to shrink its balance sheet by selling bonds and removing money from the financial system.

If the Fed needs to slow or pause its tightening efforts to ensure stability in the Treasury market, however, it could lose a crucial tool in its inflation-fighting toolkit.

This could potentially make it harder for the central bank to bring inflation down to its 2% target.