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Economic and Market Commentary

Fiscal Arithmetic and the Global Inflation Outlook

Debt-financed fiscal policy is driving much of today’s high inflation, but as pandemic-era measures fade, central banks will likely return to their key role in managing price levels.
Executive Summary
  • Growth in government debt has been a key driver of post-pandemic inflation in advanced economies. Monetary policies, while certainly accommodative, appear to have been less of a factor.
  • In response to the pandemic, central banks slashed interest rates and quickly launched quantitative easing (QE) programs that purchased interest-bearing government bonds paid for with new base money. But government treasuries, via their claim on central bank profits, are still on the hook for the interest payments on the newly created floating-rate reserves. And since 2022, those interest rates have risen sharply.
  • Once the permanently higher price levels driven by the fiscal expansions are absorbed, central bankers have the tools to guide inflation back toward their target, although this will take time.

What is driving the stubbornly high inflation evident in most advanced and emerging economies?

The complete answer may depend on where you live. The war in Ukraine pushed energy inflation higher in Europe. Weaker currencies have contributed to higher goods inflation in Japan and the Nordics. And soaring agriculture prices have raised food prices in many regions, particularly emerging markets.

Fiscal policy and government debt: key inflationary pressures

While the sources of inflation vary, a major driver in many regions is debt-financed fiscal policy. Much of this policy was debated and enacted rapidly in 2020 in an effort to directly support households and businesses during the COVID-19 pandemic. As this government-financed funding flowed into the economy, demand for goods and services rose significantly in the following years (in many cases amid supply constraints), and price levels rose.

In advanced economies, there’s a significant positive relationship between core inflation and sovereign debt growth since the start of the pandemic (see Figure 1). Different fiscal approaches among these countries likely contributed to the wide variation in their inflation trajectories (we also note there’s typically a lag between enacting policy and seeing its impact in the inflation data). On the one end, New Zealand, the U.K., and the U.S. have seen double-digit core inflation and high government debt growth. On the other end, Japan and Switzerland have seen much smaller increases in both government debt and core prices. The euro area lies in between.

Figure 1 is a scatter chart plotting the correlation between core inflation and government debt growth in advanced economies in the post-pandemic era. As described in the preceding paragraph, many countries show a distinct correlation of rising government debt and increasing inflation. The U.S., for example, saw cumulative core CPI (consumer price index) inflation from Dec. 2019 – Dec. 2022 of above 13% and cumulative debt growth of more than 25% between 2019 and 2021. Japan, correspondingly, saw core CPI inflation of less than 2% and debt growth of around 5% over the same time frame. Data sources are Haver Analytics data from national statistics offices on consumer price indices through December 2022, and OECD and Eurostat data on government debt through December 2021.

Historical perspective

In certain respects, the fiscal expansions and resulting price level increases this decade resemble the situation during and after the two world wars, as well as the 1918 influenza pandemic. Massive spending especially in wartime drove government debt levels to dramatic highs in many countries – in the U.S., for example, the debt-to-GDP ratio reached 106% in 1946, according to the Congressional Budget Office (CBO). These levels eventually decreased amid a multi-decade postwar economic expansion – including periods of significant inflation.

In 2008, the global financial crisis (GFC) triggered fiscal support to bolster a struggling economic and financial system. But much of this government financing was directed to businesses and (we would argue) came with expectations of future tax hikes or spending cuts to help improve the overall fiscal trajectory.

Today, the global economy is gradually exiting a period of extraordinary fiscal policy interventions, but the pandemic-related deficits are larger than GFC-era deficits and are directed to households along with businesses. And current political sentiment in many countries suggests less appetite to limit the government balance sheet via increased taxes or curtailed spending – suggesting debt levels could keep climbing. This could limit fiscal capacity to address future crises. In the U.S., for example, the debt-to-GDP ratio is approaching its World War II high, and the CBO sees it continuing to rise over the coming decades. (For details, please read PIMCO’s latest Secular Outlook, “The Aftershock Economy.”)

Policy, debt, and inflation: the changing arithmetic

Central banks responded swiftly to the pandemic-driven economic and market crisis, slashing interest rates and launching quantitative easing (QE) programs that purchased interest-bearing government bonds paid for with new base money. These monetary actions complemented fiscal expansion, and in retrospect, highly accommodative fiscal and monetary stimulus (enacted by policymakers facing a global emergency) likely led to imbalances relative to the post-pandemic aggregate supply of goods and services.

In our view, however, central bank policy – especially QE – likely played more of a supporting role than a leading role in causing spikes in national price levels. Looking across advanced economies, there’s a much weaker relationship between core inflation and growth in the monetary base since the start of the pandemic (see Figure 2) than we observe with growth in government debt, shown in the previous figure.

Figure 2 is a scatter chart that includes the same countries and the same data on inflation (core CPI) as Figure 1, plotted against the growth in the monetary base (driven by central bank activity). As described in the preceding paragraph, the overall trend shows only limited correlation between monetary expansion and core inflation. The U.S., for example, saw cumulative core CPI inflation from Dec. 2019 – Dec. 2022 of above 13% and cumulative monetary base expansion of about 80% between 2019 and 2021. Australia, by contrast, saw inflation above 12% while its monetary base expanded around 340% over the same time frame. Data source is Haver Analytics data from national statistics offices on consumer price indices through December 2022 and on monetary base growth through December 2021.

What explains this more limited apparent contribution to inflation from an expanded monetary base?

At a high level, while fiscal policy determines the quantity of government liabilities, monetary policy merely changes their composition. Unlike government deficits, quantitative easing does not place net new assets in private hands, but swaps one type of asset – fixed-rate interest-bearing government bonds – for another: central bank reserves that pay a floating interest rate that generally hews very close to the return on short-term sovereign assets, such as U.S. Treasury bills.

This change in the composition of the debt on the government’s overall balance sheet (i.e., both the treasury and the central bank) is important: Central banks now pay interest on reserve balances. This fundamentally changes the relevant “fiscal arithmetic.” QE does not extinguish debt, nor does it zero out the coupons on that debt: The treasury, via its claim on central bank profits, is still on the hook for the interest payments on the newly created floating-rate reserves. QE has in fact shortened the overall maturity profile of government debt by swapping long-maturity fixed-rate bonds for overnight, floating-rate reserves. And as central banks in the past year-plus have raised interest rates dramatically in an effort to tame inflation, central bank profits on those reserves rapidly eroded, increasing the net cost for the government. Here’s how: Either the central bank remits less in profits to the treasury over time, or (at the Bank of England and the Swedish Riksbank) the central bank crystallizes some of those net present value losses by actively selling bonds in the secondary market, effectively destroying reserves.

In summary, in the current regime where governments essentially are paying interest on reserves (and at a high rate relative to post-GFC recent history), the fiscal authority can no longer enjoy the seeming “free lunch” provided by a central bank that prints zero-interest money to pay for government bonds.

Implications and outlook

So what is next? The fiscal expansions delivered this decade will likely lead to price levels adjusting permanently higher. But this is not the same thing as permanently higher inflation: Our base case is that as temporary pandemic-related deficits gradually normalize, inflation is likely to diminish – and today’s restrictive monetary policies aim to accelerate this process. And unlike in the 1970s, monetary policy credibility appears intact, with medium-term inflation expectations still anchored around central bank targets.

We also recognize a range of potential inflationary pressures over the secular horizon (arising from policy, geopolitics, labor markets, etc.) that pose risks to our base case. Persistent elevated inflation could lead to inflation expectations adapting higher, a risk that central banks are seeking to mitigate via decisive monetary policies.

Although the pandemic-related fiscal deficits were temporary, it will take time for their full effect to filter through to activity and inflation. Prices and wages tend to be sticky and firms are generally slow to adjust their prices. The fiscal deficits have left the private sector with a large savings surplus – and households typically don’t spend all of their excess savings immediately but instead smooth their consumption over time. As a result, although the initial fiscal shock was temporary, we expect it will take time for prices to adjust to the permanently higher level required to offset the fiscal shock.

Once the price level adjustments from the fiscal shocks are absorbed (meaning businesses, policymakers, and consumers have largely accepted and plan for these permanently higher prices), central banks will likely return to their traditional role in directing the future inflation path. We expect them to keep winding down their QE programs, and perhaps a pervasive “QE fatigue” will set in that raises questions about central banks’ ability and appetite for extraordinary policy in the next crisis.

Looking beyond QE, we still believe central banks plan to do whatever it takes to keep inflation expectations anchored at their inflation targets, but those targeting 2% may tolerate “2-point-something” inflation for a while as part of an “opportunistic disinflation” strategy – i.e., they expect a shortfall in aggregate demand during a future recession to return inflation to target from above.

The pandemic serves as an important reminder that it takes two to tango, and that price stability requires not just prudent monetary policy but appropriate fiscal backing too. Higher interest rates have worsened fiscal trajectories, and in the long run, governments may need to adjust future tax and spending plans to avoid a situation in which fiscal dynamics return to the driver’s seat of shaping inflation.

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