Inflation could reduce public debt. But the Fed shouldn’t be wrong.



About the Author: Leslie Lipschitz is the former Director of the IMF Institute, taught at Johns Hopkins University and Bowdoin College, was a Visiting Fellow at the Brookings Institution and Advisor to Investec Asset Management.

In August 2020, well before recent increases in inflation, Federal Reserve Chairman Jay Powell announced that the Fed’s monetary policy framework would change to a 2% inflation target. on average overtime. As inflation has been below target for some time, the Federal Open Market Committee would target inflation just above 2% in order to reach an average rate of 2% over a period (unspecified). The Fed has now embarked on a modest reduction in stimulus measures, a monthly reduction in its asset purchases. Nonetheless, he attributes the high inflation so far to transient factors which, he argues, have not dislodged the longer-term 2% peg from inflation expectations. Under these circumstances, economists cannot help but think of another implication of higher inflation: its effect on public debt.

Debt considerations are outside the mandate of central banks and the purview of monetary policy. Indeed, avoiding “fiscal dominance” – a situation in which monetary policy is driven by fiscal targets to the detriment of inflation targets – has been a critical aspect of monetary policy making. The move towards greater independence of central banks from political considerations has been motivated by the objective of strengthening the efficiency and credibility of central banks with regard to their narrow mandates.

No one would accuse the Fed of succumbing to fiscal dominance now. But the calculations of how inflation, without a proportional increase in inflation expectations and therefore interest rates, would affect public debt are too obvious to be ignored, at least analytically.

According to the latest IMF World Economic Outlook, US public debt stood at 134% of GDP in 2020, a level unimaginable a few years ago. (The debt ratios of some European countries are even more alarming and also raise troubling questions about debt sustainability, that is, a possible stabilization of the debt-to-GDP ratio at a manageable level.) High debt levels increase the budget’s sensitivity to higher interest rates and are generally associated with financing costs that crowd out other areas of public spending. While debt ratios are not reduced during bullish phases, they increase repeatedly with each slowdown, ultimately limiting the government’s ability to cope with the next shock or, in extreme cases, raising fears of a crisis. budgetary and financial. Therefore, few would dispute that a primary objective of post-pandemic macroeconomic policies is to reduce the public debt ratio.

But reducing public debt after a peak is difficult. There are four critical influences on the path of the debt ratio: real GDP growth, the government’s primary fiscal balance, interest rates, and inflation.

Higher growth is useful, but is often insufficient: it is limited by slow fundamental supply conditions and cannot be turned on or off.

Reducing the primary deficit (the deficit excluding interest payments) through budget cuts (less spending and / or higher taxes) is always politically difficult, even when it is obviously the right thing to do. As Jean-Claude Juncker, former President of the European Commission would have said: “We all know what to do, but we don’t know how to get re-elected once we have done so.

The influences of interest rates and inflation are closely related. The Fed may be able to keep short-term rates low, but longer rates are influenced by inflation and growth expectations. However, to the extent that expectations are seen as “well anchored” – in the precise sense that market interest rates do not fully anticipate higher inflation – higher inflation reduces the debt ratio. A negative real interest rate (a rate lower than inflation) is, in effect, a tax on money holders and creditors – albeit an invisible rather than explicit tax – and a subsidy to debtors ( including, prominently, the government). The higher the debt, the greater the gain for debtors.

Consider some extrapolations for the United States Suppose the nominal interest rate on government debt is frozen at 2%, the general government primary deficit is gradually reduced from 12.5% ​​of GDP in 2020 to a sustained level of 3.5% from 2023, that the GDP grows by (the IMF projection of) 9.7% in nominal terms in 2021, and that thereafter, the economy grows by 2% in real terms, which is close to most potential estimates. With constant inflation of 2% from 2022, the general government debt ratio reaches 139% in 2025 and 143% in 2030. If, however, inflation were to remain at 6% from 2022 until the end of the decade, the debt ratio would be reduced to 120% by 2025 and to 106% by 2030. (For some European countries, Italy and Greece for example, the reduction in the debt ratio due to higher inflation higher would be even more important.)

These numbers raise an obvious question: isn’t there a temptation (albeit inconsistent with the Fed’s mandate) to let the effect of high inflation on debt play for a while?

The answer: It may be tempting, but it would be madness.

First, to significantly reduce debt, inflation must outlast any realistic idea of ​​”transitory”. It would be deeply unpopular. Inflation has already been painful, especially for retirees, other people on fixed incomes, and risk averse savers (millennials could be first-time home buyers) who see their financial wealth. erode.

Second, is it possible to have well-anchored inflation expectations if inflation stays at the current level for a while? Already, despite the Fed’s statements on the duration of the rise in inflation, fears that it will last longer are omnipresent. Port congestion and transport bottlenecks are unlikely to disappear this year, housing price increases are not yet fully reflected in consumer prices, investments in domestic fuel production are hampered by environmental considerations, OPEC oil producers are reluctant to increase production, Russia’s policy of limiting fuel exports to Europe for political leverage may have broader implications, and Wage deals will eventually incorporate and anticipate higher prices.

Third, economists debate the level at which inflation begins to exert a negative influence on growth. Lower growth, especially if accompanied by expectations of inflation and higher interest rates, would be devastating for the control of public debt and the stability of financial markets, among others. Rightly, there has been a lot of thinking recently about the experience of the 1970s when a flawed policy response to a supply shock caused double-digit inflation in 1974 and 1981. To regain control, he has It took astronomical yields on government debt (peaking at or above 16% for maturities of 2 to 30 years) and a severe recession.

These considerations suggest that we must resist any temptation to view inflation as a debt reduction instrument. It is implausible that the Fed will allow fiscal targets to divert monetary policy from its specified and limited targets, but contrary inferences should be squashed by both policies and statements.

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