The growth of the federal deficit in the post-COVID era, coupled with the political unwillingness to increase taxes, foretells higher-than-historical inflation rates, according to new research.
The fiscal theory of the price level has been around since the early 1990s. The research on the theory was summarized and extended in John Cochrane’s 2023 book. As Cochrane explained, prices adjust so that the real value of government debt equals the present value of taxes less spending. Inflation breaks out when people don’t expect the government to fully repay its debts.
With the theory in mind, Robert Barro and Francesco Bianchi, authors of the November 2023 study, “Fiscal Influences on Inflation in OECD Countries, 2020-2022,” examined the role of fiscal expansion as a determinant of inflation rates in 37 OECD countries over the period 2020-2022. They used the key ingredients of the fiscal theory of the price level to work out a relation between inflation rates and government spending, and applied this specification to measures of headline and core CPI inflation rates along with information on changes in general government primary expenditure, public-debt levels and debt duration.
They began by hypothesizing that the rise in government spending stimulated by the COVID recession was accompanied by the expectation that the large, unexpected increase would not be matched fully by rises in current or future revenue or reductions in future spending. Instead, the government’s intertemporal budget constraint would have to be satisfied through a cut in the real market value of public debt – inflating it away. The authors explained: “If the public debt is denominated in domestic currency, this depreciation of the real debt could be accomplished – in the absence of formal default – by increases in current or future price levels; that is, by a sustained period of inflation that was unexpected prior to period.” Following is a summary of their key findings:
- The cumulative rise in ratios of debt-t-GDP over 2020-2022 compared to the ratio in 2019 averaged 0.122 for primary government spending and only 0.016 for government revenue.
- The data revealed clear positive slopes that were statistically highly significant and were not driven by extreme observations (the higher U.S. inflation rate was not an outlier).
- Debt duration was statistically significant for explaining inflation rates – longer duration smoothed out the rise in inflation over longer periods.
- Countries that share a common border with Ukraine or Russia were found to have substantially higher inflation rates than would otherwise be predicted. These effects could be viewed as reflecting choices to finance more or less of government expenditure through inflation or to deviate more or less from the smoothing of inflation rates to place more or less weight on short-term inflation.
- For headline CPI, the average annual inflation rate for the 21 economies was 1.9% in 2019, 1.4% in 2020, 3.1% in 2021, 8.2% in 2022 and 5.5% for the third quarter of 2023. The corresponding values for core CPI inflation were 1.9%, 1.7%, 2.4%, 5.7% and 5.7%. The empirical pattern – which does not contradict the main implications of the theory – was that inflation built up gradually and eventually leveled off and started to fall.
- The point estimates of coefficients of 0.4-0.5 suggested that 40%-50% of the extra spending was financed through inflation, whereas the remaining 50%-60% was paid for through intertemporal public finance that involves increases in current or prospective government revenue or cuts in prospective future spending.
Summarizing their findings, Barro and Bianci noted: “In response to the COVID pandemic, many countries implemented large increases in deficit-financed government spending from 2020 to 2022. To the extent that these fiscal interventions were perceived as not backed by current and future tax increases or future spending cuts, the fiscal theory of the price level, FTPL, predicts that countries should experience a rise in their inflation rates. … The predicted increases in inflation rates are proportional to the size of the fiscal stimulus, measured by the cumulative increases in ratios of spending to GDP.” That led them to conclude: “We find support for these theoretical predictions of the FTPL. … The estimation of a well-specified equation supports the idea that the recent fiscal expansion has been a key driver of inflation rates in the OECD countries.”
Investor takeaways
The U.S. federal government has been engaging in massive fiscal stimulus, running a budget deficit of about $1.7 trillion in 2023, or about 6.3% of GDP, at a time of full employment (when we should be running surpluses to slow economic demand). Without an accounting change related to the administration’s aborted student loan cancellation program, the deficit would have been closer to $2 trillion (or about 7% of GDP), double the amount from the prior year. In projections released in October 2023, the International Monetary Fund projected U.S. deficits will reach 6.8% of GDP in 2024, 7.1% in 2025, and remain above 6.6% through 2028.
Given the size of the projected deficits and no evidence of the willingness of either political party to address their unsustainable nature by cutting spending and/or increasing taxes, the fiscal theory of the price level suggests that while inflation has fallen to well below peak levels, the risks of higher inflation are greater than the market expects. As of November 10, the spread between the 10-year Treasury bill (4.61%) and the 10-year TIPS (2.29%) was just 2.32%, close to the Fed’s inflation target of 2%. Thus, the “right tail” risk of higher inflation seems to be much greater than the “left tail” risk, arguing for caution before considering extending bond maturities beyond the relatively short-term.
Given the yield on TIPS, close to the highest level since early January 2009, TIPS are more attractive than nominal bonds – especially given the Fed’s target for inflation of 2%, indicating it doesn’t want to see inflation much below that level.
For advisors and investors concerned about the risks of inflation, the empirical evidence provides a note of caution. Rob Arnott and Omid Shakernia, authors of the study, “History Lessons: How 'Transitory' Is Inflation?” analyzed the behavior of inflation across 14 developed economies once a country’s inflation rate surged past various thresholds, and studied how long a burst of inflation typically lingered. Following is a summary of their findings:
- When inflation reached a 4% level, the lowest quintile of outcomes took less than three years to revert back to 2%. The reversion to 2% took at least 18 years at the highest quintile of outcomes. The median reversion to 2% was eight years.
- When inflation reached the 4% threshold but did not exceed 6% (the second threshold), the median reversion was two years to fall back to 2%. If the second threshold was reached, a protracted period of high inflation was observed to follow. The reversion back to a 2% target took an average of 15 years. If the level of inflation proceeded to the third threshold of 8% and continued to accelerate, the average reversion to 2% took 16 years. If inflation failed to accelerate (cresting inflation), the reversion dropped to 3.5 years on average.
- For the highest thresholds from 18% to 20%, inflation tended to resolve much faster, possibly due to central bank intervention. But the number of observations was insufficient to provide much confidence in the result. The worst quintiles observed at every level of inflation exhibited a reversion to 2% between 18 and 22 years.
Their findings led Arnott and Shakernia to conclude: “If history is a guide, inflation can take far longer to return to normal levels than most people realize.”
While it is possible that this round of high inflation will prove to be transitory (the rate peaked at 9.1% in June 2022 and had fallen to 3.2% in October 2023, though the core year-over-year CPI increase was still 4.0%), it is not certain, especially in light of the outlook for fiscal deficits.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third party data is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securities and Exchange Commission (SEC) nor any other federal ot state agency have approved, determined the accuracy of, or confirmed the adequacy of this article. LSR-23-586
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