We Can't Inflate Our Way Out

February 23, 2010

By Richard Berner
New York



Inflation is not the solution. It's tempting to think that the US can inflate its way out of its fiscal problems. A faster, sustained increase in prices would erode the real value of past debt, and higher future inflation would - other things equal - reduce the real resources needed to service and pay back the promises we are making today. And there is no mistaking the staggering value of those promises. On our projections, federal marketable debt held by the public, which we estimate will be 60.7% of GDP at the end of F2010, will jump to 87% of GDP in the next decade - a level not seen since the post-WW II period (1947). In absolute terms, such debt will more than double over that period from its January level of US$7.2 trillion.


Adding fuel to the fire, a growing chorus of household-name economists from both sides of the political aisle appears to be advocating higher inflation as the remedy for our fiscal maladies. Indeed, many believe that higher inflation will cure multiple ills, and that central banks should raise their inflation targets to as high as 4% from the current ones (some implicit) that cluster near 2%. From a policy perspective, we couldn't disagree more. As we see it, central bank responses to this financial crisis underscore the fact that inflation targets are medium-term goals to be met flexibly; they have not limited central banks from responding aggressively to the shock. Specifically, we believe that the Fed's ‘credit easing' programs have restored the functioning of many financial markets and enabled policymakers to offset the constraint of interest rates at the ‘zero bound'. But the push for allowing more inflation to lubricate the economy is gaining adherents, so it's time for sober analysis.



Our inflation view. Let's be clear: Our view is that inflation will stay low - at or below 2% - for the next two years. Near term, we expect that significant slack in goods, labor and housing markets will promote a decline in core inflation toward 1%, measured by the core CPI. January's 0.1% decline in the core CPI is on track with that view. Subsequently, we believe that narrowing slack, rising inflation expectations and commodity prices will promote a gradual move in core inflation back to 2% in 2011.



However, there are some inflation tail risks: Monetary policy globally has been ultra-expansionary; left unchecked, massive fiscal deficits could eventually pose an inflation threat, and central banks, especially the Fed, find themselves under more political pressure than at any time since the Great Depression. So, the fear that the Fed cannot take away the punchbowl any time soon is understandable. While those tail risks are currently small, we agree with our colleague Joachim Fels - who has been warning of inflation risks for some time - that investors should consider inflation insurance. But a recommendation to buy protection against inflation tail risks is very different from expecting that inflation will - or could - rise by enough to erode the value of the debt.



Flawed strategy: Three hurdles. Indeed, we think three hurdles preclude eroding the real value of our debt with inflation. 1) Investors would recognize even a stealth inflation policy and would quickly push up yields. 2) Nearly half of federal outlays are either officially or unofficially indexed, meaning that increments to debt would rise with inflation. 3) And the Fed is unlikely to acquiesce. Before examining those factors, it's worth looking back to see what history suggests.



The lessons from history may not apply. On the surface, it appears that history contradicts our view. After all, the combination of seignorage (the benefits to the sovereign from printing money) and unexpected inflation of the mid-1960s and 1970s pushed real rates sharply negative, limiting debt service and eroding the debt.



My colleague Spyros Andreopoulos explores this issue in depth in a provocative recent piece (see The Return of Debtflation? February 10, 2010). His calculations show that rapid nominal growth brought debt held by the public from 108.6% of GDP in 1946 to just 36% of GDP in 2003. The calculations further show that inflation accounted for 56% of that decline, while real growth accounted for the remainder.



Spyros acknowledges that his calculations implicitly assume that debt service is a constant share of GDP. In reality, debt service varies with changes in interest rates, in the debt, and in the maturity structure of the debt. So, if debt is growing relative to GDP and rates are rising with inflation, debt service/GDP will also rise, boosting the overall deficit and debt/GDP. That limits the ability of policymakers to inflate the debt away. Indeed, using an alternative framework, George Hall and Thomas Sargent calculate that during the period from 1945 to 1974, inflation accounted for only about 23% of the decline in debt/GDP.



Those assumptions are critical in evaluating history, because it turns out that the US post-war experience was anomalous for three reasons. First, a rapid decline in defense spending yielded a significant ‘peace dividend'. Even with the GI Bill and the Korean War, defense spending tumbled from 37% of GDP in 1945 to 11% by 1955, bringing the deficit from 12% of GDP in 1945 to outright surplus by 1947. Second, the Fed implicitly agreed to finance the war by holding down interest rates through the early 1950s. The Korean War brought a surge of inflation and a recognition that the Fed needed more independence. In 1951, the Treasury-Fed Accord empowered the Fed to raise interest rates to address inflation. Finally, wartime legislation prohibited the Treasury from issuing bonds with coupons greater than 4.25%. Consequently, debt managers shortened the maturity of issuance to get under the ceiling. Higher inflation and market pressures eventually forced repeal and also brought down debt/GDP.



Hurdles to inflating. Looking ahead, as noted above, there are several hurdles to being able to inflate away the debt. First, market participants seem unlikely to be fooled by unexpected inflation - certainly not for long enough or by enough to dent the debt. Despite what some might view as inflation complacency, the transformation of financial markets over the past 50 years, including the growing use of instruments to protect against inflation, suggests much more sensitivity to inflation risks than in the post-war period.



Indexation. Second, nearly half of federal outlays are linked to inflation, meaning that increments to debt would rise with inflation. Social Security, which accounts for one-quarter of Federal outlays, is officially indexed, and Medicare and Medicaid are ‘unofficially' indexed. Indeed, over the period 2009-20, CBO estimates that these three programs will account for 72% of the growth in total federal outlays and about the same share of the growth in debt. If anything, CBO's assumptions may be conservative, as they are required under current law to assume a sharp cutback in physician reimbursement payments under the Medicare program. Those cuts have been delayed every year since 2003.



Enter the Fed. Finally, while many view the Fed as politically constrained, we have no doubt that Fed officials will not tolerate a significant rise in inflation, much less encourage it. Of course, starting in the mid-1960s through 1979, monetary policy did appear to sanction higher inflation. Having been at the Fed from 1972 to 1980, I wouldn't say that then-Chairman Arthur Burns explicitly chose inflation; rather (and somewhat incomprehensibly) he didn't think inflation had much to do with monetary policy.



That was then. As much as the Fed seems to be in disfavor today, there is no question among even its sharpest critics that the Fed should be independent and responsible for price stability. And Fed officials are acutely aware of the pressure that large deficits put on the central bank. As Kansas City Fed President Hoenig noted recently, "The founders of the Federal Reserve understood that placing the printing press with the power to spend was a formula for fiscal and financial disaster."



Venting market pressures: Rates or currencies? Even setting aside all those hurdles, with core inflation declining again, it would take some time to boost inflation sufficiently to meaningfully erode the debt. That's all the more reason to pay attention to the other ways that fiscal pressures may vent in financial markets. Put simply, sovereign credit risk may not immediately create inflation risk; it may instead translate into real interest rate or currency risk. Indeed, our call for a rise in nominal 10-year Treasury yields to 5.5% is a story about real rates, in which a revival of private credit demands collides with massive Treasury borrowing needs. Global investors will likely demand a concession to buy US debt, or they will diversify away from it. Financial markets will, when provoked, find ways to ‘punish the printers' - in this case, meaning those whose fiscal policies are clearly on an unsustainable path.



That's especially a risk in the current US political setting. The decisions to retire by key senators on both sides of the political aisle are partly the result of moves to the left by Democrats and moves to the right by Republicans. With both parties losing their moderate members in the middle, the distance between them becomes ever harder to bridge, and there is less mass in the center to achieve practical solutions. And practical solutions to our budget and economic challenges are needed soon, in our view.



For financial markets, there is an element of complacency around such gridlock. Market participants are used to thinking that political gridlock is good: It prevents politicians from interfering with the marketplace. The financial crisis clearly exposed the flaws in that reasoning with respect to appropriate financial regulation. Indeed, gridlock today is more likely to be bad for markets, as our budget problems are directly the result of past policies and can only be solved with political action. The risk is that further significant upward pressure on interest rates - significant enough to be perceived to threaten the expansion - may be needed before leadership emerges to break the logjam.