Can the US Fiscal Deficit Cause Inflation?

We explore the argument that today's fiscal deficit will incite renewed inflation in the coming years.

Inflation or deflation? Boom times or recession? It seems that with each passing day, arguments on either side grow stronger and more entrenched. And while we have expressed a bias toward the latter of each question, it is not good form as researchers to stay wedded to a thesis when the data or markets suggest otherwise. For that reason, we are constantly looking to confirm or reject our theses.

Lately, we have been presented with some data that suggests inflation has bottomed, including stabilizing housing prices, massive Chinese stimulus afoot, and a weakening dollar which should give life to suppressed commodity prices. But another contributor exists—the fiscal deficit of the United States. Let’s dive into a recent Lyn Alden piece and dissect whether deficits can override the disinflationary effects felt elsewhere in the economy.

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Where does it come from?

We recommend you take a look at Alden’s piece titled “Do High Interest Rates Fix High Inflation?”, in which she lays out her thesis that high rates and sizable fiscal deficits are a recipe for inflation, and that trying to determine if the disinflationary impact of higher rates will dominate or submit to inflationary impulses is a tall task.

In the interest of saving you time, we present the core of Alden’s argument—instead of trying to overly convince you on which side of the coin we’ll end up, she elegantly summarizes the conundrum:

Each increase in interest rates puts some disinflationary pressure on the private sector, but also results in even larger public sector deficits pouring money into the economy. If those public sector deficits are big enough, then high interest rates can actually be inflationary.

In today’s post, we give merit to each side but present an additional factor that we believe will have the most influence: consumer and corporate behavior.

And before we can proceed, we must deliver an obligatory plug for Alden’s new book titled “Broken Money” which will be coming out soon. Can’t wait to read it!

Now, to the source of inflation. Alden argues that inflation comes from either bank lending or fiscal deficit spending. When banks lend money, new money is created; when governments borrow and spend, the private sector is the primary beneficiary—a government’s deficit is the private sector’s surplus.

Even though there are these two separate sources of inflation, central bankers use the same set of tools to fight it. We say tools, but it’s really one tool: higher rates.

Rates: moving on up

When higher rates are levied on an economy, two things happen to consumer behavior. First, the consumer’s marginal impulse to borrow and spend declines—all else being equal, making borrowing more punitive will influence those with modest incomes to keep those wallets inside their purses and pockets. You can also think of it like the proverbial “gas tax”—when gas prices go up, some (not all) drivers will skip that extra road trip.

Second, savings increase. Consumers must consume, but consumers also do, on occasion, choose to save. Higher rates not only make things more expensive, but they also increase interest income from safe investments, therefore influencing behavior to try and motivate people to hold on to their money.

But do higher rates bring another set of implications that are slightly removed from directly influencing consumer behavior? Alden argues yes: high rates coupled with large fiscal deficits send inflation higher. For example, in the 1940s, World War II forced the US government to reach deep into the future’s pocket to build airplanes, tanks, and fund the takedown of the Axis. The result? Inflation. Let’s take a look at this dynamic with two Alden charts.

In this first graph, the gray line represents money growth, which overall is the driver of inflation, regardless of the source (bank lending or government deficits). The orange and blue lines represent the two sources, helping us identify where the growth comes from during each spike. You’ll see that in the 1940s, the gray line spikes along with the blue only, meaning that money growth came from the fiscal deficit. In the 1970s, the last major inflationary era prior to the current one, bank lending (driven largely by baby boomer demographics) led the way, while deficits were quite muted. Lastly, the current period is characterized by deficits, and importantly, not lending:

Now, let’s bring in CPI, which measures inflation for consumers. This graph plots inflation versus money growth and helps demonstrate the strong relationship between the two. The 1940s spike and 1970s spike were both joined by an increase in the money supply, which again can come from the private or public sector. Currently, the inflation wave sweeping the globe is still subdued on a 5-year cumulative growth basis—in other words, while we hit 9% inflation last summer, the rapid drop to 3% has the cumulative inflation for this pandemic and post-pandemic era contained, and quite substantially, relative to the 40s and 70s. Nevertheless, cumulative inflation still has reached around 20% for the decade, while broad money growth more closely mirrors a time in which cumulative inflation topped 50% (1970s):

Alden argues that high interest rates on large amounts of government debt will result in even bigger runaway deficits; even though rate hikes are the chosen tool to slow inflation, they can ironically push more money into the economy. Just look at how much interest income is flooding into the system:

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It must be the deficit, right?

Alden makes it clear that neither higher rates nor a large fiscal deficit can truly affect the economy and inflation in such a short time horizon. We’re all hopefully aware that monetary policy operates with a lag, meaning that rate hikes don’t end up influencing consumer and corporate behavior until several months have passed. That means next week’s rate hike (as long as nothing material changes in the next few trading sessions) won’t actually hit the economy, marginally speaking, until 2024.

But this is where we present a third alternative to the inflation versus deflation argument: what if inflation expectations matter even more than either bank lending or fiscal deficit spending? We answer that question with a rhetorical one: why has inflation normalized back down below 3% from 9% in 12 months?

Now that information spreads at the speed of light, hawkishness and the widespread fear of recession have brought down consumer spending to target. We present the reader with the idea that the current bout with inflation is driven primarily by expectations. Rate hikes are clearly working—with mortgage rates above 7% and credit card rates going haywire, the Fed must be working on something quite specific to bring down CONSUMER price inflation. Perhaps in the information age, the Fed is working on the consumer itself:

During the Great Financial Crisis of 2008-2009, fiscal deficits exploded. Inflation did not. We might see this type of relationship repeat itself this time around because the disinflationary effects from higher rates are really showing up in bank lending and consumer behavior:

Here are the two graphs from Bloomberg’s Lisa Abramowicz’s tweet, showing declining bank lending from both small and large banks:

—and declining commercial and industrial lending expected to contract even more in the coming months:

Economists often attribute persistent inflation to a lack of workers, leading to increased wages and fueling an inflation cycle—this is closer to what we’re experiencing now and certainly presents a threat to CPI heading into 2024. We also cannot argue with the empirical evidence presented by Alden that monetary stimulus aiding fiscal deficits can cause serious inflation. But the disinflationary forces of lending contraction and consumer behavior itself might prove challenging to the thesis that the US fiscal situation will cause the next inflation run. Especially if the current one is already on its way out.

We’d like to thank Lyn Alden for her fantastic work and appreciate her in-depth research that brings more data and history to our framework. Over the coming months, we’ll be able to determine whether Jerome Powell’s hawkishness proves successful in squashing inflation or if it triggers a boomerang effect due to the fiscal profligacy brought on by the 535+1 members of the legislative and executive branches.

Until next time,

Nik & Joe

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