About the author: Leslie Lipschitz is the former director of the IMF Institute, has taught at Johns Hopkins University and Bowdoin College, been a guest scholar at the Brookings Institution, and an advisor at Investec Asset Management.
In August 2020, well before the recent increases in inflation, Federal Reserve Chairman Jay Powell announced that the Fed’s monetary policy framework would shift to targeting inflation of 2% on average over time. Because inflation had fallen short of the target for some time, the Federal Open Market Committee would aim for inflation moderately above 2% so as to achieve an average rate of 2% over some (unspecified) time period. The Fed has now embarked on a modest reduction in stimulus—a monthly scaling back of its asset purchases. Nevertheless, it attributes elevated inflation thus far to transitory factors that, it asserts, have not dislodged the longer-term 2% anchor for inflation expectations. In these circumstances, economists cannot help thinking about another implication of higher inflation: its effect on government debt.
Debt considerations are outside the mandate of central banks and beyond the purview of monetary policy. Indeed, avoiding “fiscal dominance”—a situation where monetary policy is driven by fiscal objectives at the expense of inflation objectives—has been an essential aspect in the development of monetary policy. The movement toward giving central banks greater independence from political considerations has been driven by the objective of strengthening the effectiveness and credibility of central banks with respect to their narrow mandates.
No one would accuse the Fed of succumbing to fiscal dominance now. But calculations of how inflation, without a commensurate increase in inflation expectations and thus interest rates, would affect government debt are too obvious to be ignored, at least analytically.
According to the latest IMF World Economic Outlook, U.S. general government debt amounted to 134% of GDP in 2020, a level unimaginable just a few years ago. (The debt ratios for some European countries are even more alarming and also raise troubling questions about debt sustainability—that is, an eventual stabilizing of the debt-to-GDP ratio at a manageable level.) Elevated debt ratios increase the sensitivity of the budget to higher interest rates and are usually associated with financing costs that crowd out other areas of government spending. If debt ratios are not reduced during upswings, they are ratcheted repeatedly upward in each downturn, circumscribing, eventually, the ability of the government to deal with the next shock or, in extreme cases, raising the specter of fiscal and financial crisis. Few, therefore, would disagree that a first-order objective for post-pandemic macroeconomic policies is to reduce the government debt ratio.
But reducing government debt after a spike is difficult. There are four critical influences on the path of the debt ratio: real GDP growth, the government’s primary budget balance, interest rates, and inflation.
Higher growth helps, but is often insufficient: It is constrained by slow-moving fundamental supply conditions, and cannot be turned on and off.
Cutting the primary deficit (the deficit excluding interest payments) through fiscal retrenchment (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 is reputed to have said, “We all know what to do, but we don’t know how to get re-elected once we have done it.”
The influences of interest rates and inflation are intertwined. The Fed may be able to keep short-term rates low, but longer rates are influenced by expectations of inflation and growth. However, to the extent that expectations are believed to be “well anchored”—in the specific 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 a tax that is invisible rather than explicit—and a subsidy to debtors (including, prominently, the government). The higher the debt, the larger the gain for debtors.
Consider some extrapolations for the U.S. Assume that the nominal interest rate on government debt is frozen at 2%, that the primary general government deficit is brought down gradually from 12.5% of GDP in 2020 to a sustained 3.5% from 2023 onward, that GDP increases by (the IMF projection of) 9.7% in nominal terms in 2021, and that thereafter the economy grows at 2% in real terms, close to most estimates of potential. With inflation at a constant 2% from 2022 onward, the general government debt ratio reaches 139% in 2025 and 143% in 2030. If, however, inflation were to remain at 6% from 2022 through the rest of the decade, the debt ratio would be reduced to 120% in 2025 and 106% by 2030. (For some European countries—Italy and Greece for example—the debt ratio reduction from higher inflation would be even larger.)
These numbers raise an obvious question: Isn’t there a temptation (albeit inconsistent with the Fed’s mandate) to let the effect of elevated inflation on debt play out for a while?
The answer: This may be tempting but it would be folly.
First, to make a significant dent on debt, inflation has to last longer than any realistic idea of “transitory.” This would be deeply unpopular. Already inflation has been painful, especially for pensioners, others on fixed incomes, and for risk-averse savers (millennial would-be first home buyers perhaps) who watch as their financial wealth is eroded.
Second, is it possible to have inflation expectations well-anchored if inflation remains at the current level for some time? Already, despite the Fed’s pronouncements on the duration of higher inflation, fears that it might last longer are ubiquitous. Congestion at ports and transportation bottlenecks more generally are unlikely to clear this year, housing price increases have yet to be fully reflected in consumer prices, investment in domestic fuel production is inhibited by environmental considerations, OPEC oil producers are reluctant to increase output, Russia’s policy of limiting fuel exports to Europe for political leverage may have wider implications, and wage settlements are bound eventually to incorporate and anticipate higher prices.
Third, there is some debate among economists about the level at which inflation begins to exert a negative influence on growth. Lower growth, especially if coupled with higher inflation expectations and interest rates, would be devastating for government debt containment and financial market stability among other things. Appropriately, there has recently been much reflection on the experience of the 1970s when a mistaken policy response to a supply shock elicited double-digit inflation in 1974 and 1981. Regaining control required astronomic yields on government debt (peaking at close to or above 16% for maturities of two through 30 years) and a sharp recession.
These considerations suggest that any temptation to see inflation as an instrument for debt reduction should be resisted. It is implausible that the Fed would allow fiscal objectives to divert monetary policy from its specified and limited objectives, but inferences to the contrary should be squashed by both policies and pronouncements.
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