Should Investors Fear Inflation with the Massive Government Deficit Spending?
John Fischer, CFA®, CFP® | Chief Investment Officer
May 21, 2020
One of the questions I’ve been getting a lot from clients recently is should we be worried about inflation given the trillions of dollars in deficit spending by the government to counter the economic devastation of Covid-19? After all, government spending on various stimulus packages is roughly $2.8 trillion to date, which is expected to push the 2020 federal deficit to $3.7 trillion. The government’s debt is expected to grow to 107% of the country’s annual GDP this year, levels which we haven’t seen since World War II.
- In the short run, the risk of inflation is extremely unlikely – Last week, core inflation (which excludes food and energy) for April came in at an annualized rate of 1.4%. The Fed has targeted 2% core inflation as a level to help maintain sustainable economic growth. It should come as no surprise given the economic shutdown that consumption levels are running well below normal expectations. Overall inflation for April ran even lower at 0.3% due to depressed energy prices. In the short-term, the Fed’s bigger concern is avoiding deflation, not runaway inflation.
- The government has to put the fire out, then worry about smoke damage – The month of April brought record setting unemployment numbers and the steepest declines in retail sales and industrial production. Given the depth of economic pain caused by Covid-19, the government has a responsibility to help people and the economy survive this pandemic. The almost $3 trillion in stimulus spending may increase the risk of inflation down the road but the government needs to put the economic fire out now and then worry about potential smoke damage after the fire has been extinguished.
- The government is using a bazooka instead of a BB gun – During the Great Recession of ’08-’09, the total stimulus spending to support the economy was 4% of total U.S. GDP. Many economists believe the small size of the stimulus package and its slow injection into the economy contributed to a longer recession and slower economic recovery. The government has clearly changed its approach during the current crisis as the near $3 trillion in stimulus spending was executed quickly and its size represents a robust 13% of total U.S. GDP in 2019. The hope by government officials is that the larger stimulus plan can shorten the recession and economic recovery, thereby increasing economic activity faster. The increased economic growth and resulting tax revenues should help the government service its larger debt.
- Haven’t we been here before? – Before the ’08-’09 recession, total government debt as a percentage of US GDP was 62%. Following the end of the recession in 2010, debt had ballooned to more than 90% of GDP in large part due to stimulus spending to help the economy during the recession. Many experts decried the deficit stimulus spending as irresponsible, stating it would lead to strong inflation and hurt the economy down the road. During the past decade, inflation has struggled to get above 2%, reminding us all of the risks of following expert predictions about an uncertain future.
- Low interest rates reduce the cost of government borrowing – With the 10 year treasury near 0.70% and the 30 year treasury at 1.40%, the annual interest cost of servicing these higher debt levels is extremely manageable relative to total GDP and is reminiscent of the last time total debt was greater than 100% of GDP during World War II when interest rates were at their 20th century lows. The interest costs and repayment of this debt would be much more costly at higher interest rates.
There’s no doubt that increased deficit spending increases the risk of inflation down the road. However, it’s important to remember that as the economy recovers, it’s the Fed’s job to reduce the stimulus (i.e. raise rates) they’ve injected into the economy to promote full employment and stable prices (moderate inflation). If inflation does rise, it will likely be due to a stronger economy, leaving the government in a better position (higher tax revenues) to manage the debt payments or reduce its outstanding debt. But before the government worries about mitigating the smoke damage, they need to put the economic fire out.
Make it a great day,
Disclosure: The opinions voiced in this material are for general information only and should not be construed as personalized investment advice, including the recommendation to engage in a particular investment strategy. Past performances referenced within may not be indicative of future results and may have been impacted by events and economic conditions that will not occur or prevail in the future. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.