As at 22 June 2023
Author: Gavyn Davies, Chairman
- We are receiving questions about the future of the monetary and policy regimes after the pandemic shocks, as well as the impact of any changes in these regimes on financial markets.
- Today we will address the effects of greatly increased public debt ratios on bond markets and the impact of much higher inflation rates on central bank inflation targets.
- Fiscal stimulus during the pandemic has markedly increased the public debt ratio in the G20 advanced economies. In our view, this will not cause fiscal crises via credit and default risk in the government bond markets, but it could increase inflation risk and/or raise real interest rates, crowding out private
- Meanwhile central banks have chosen largely to accommodate a prolonged period of above-target core inflation following the pandemic. This has triggered concern about possible increases in the official 2%
inflation targets in the medium term.
- We do not expect the Fed or the ECB to change their current inflation targets, but they do appear willing to tolerate long periods in which inflation exceeds 2% after economic shocks. This is likely to lead to an upward bias in inflation relative to targets.
- In view of these developments in both fiscal and monetary policy regimes, inflation risk seems to have been permanently increased by the effects of the pandemic. This is more likely to impact the future
inflation rate in the US than in the EU.
The Fiscal Regime
Debt ratios (defined as gross government debt/GDP) have risen in two giant steps in the past 20 years, reflecting government decisions to protect the private sectors from the full effects of the Global Financial Crisis and the pandemic. IMF estimates for 2023 show the debt ratio at 122% in the US, 106% in the UK and 90% in the The G20 average debt ratio is around 10 percentage points above 2019 levels. This rise in public debt was fully accommodated by increases in central bank balance sheets – a policy mix that probably contributed to the surge in inflation, especially in 2021.
Should we be worried about these debt ratios? It is very unlikely that they will lead to debt default crises in government bond markets since major advanced economies can always choose to print money in preference to defaulting on their debt. In the US, the debt ceiling is an added complication, but ultimately the ceiling is likely to be raised by Congress whenever there is a genuine risk of default, as has occurred in 2011, 2013 and 2023.
However, rising public debt can lead to higher inflation, especially if central banks choose, or are instructed, to hold down interest rates or print money to finance public deficits. John Cochrane (Hoover Institute, Stanford University) is the most important advocate of the “fiscal theory of the price level”, under which the central banks are forced by governments to accommodate rising inflation. This outcome, known as “fiscal dominance”, was feared in the UK under the Truss government in 2022, and actually happened in the US in the early 1970s, so it is certainly not an impossibility in an advanced democracy.
The inflationary risk from fiscal dominance is greatest in countries where budget deficits are maintained at “unsustainable” levels, implying that debt ratios are set on permanently rising paths. The US represents the main problem here because the budget deficit is projected to remain above 7% of GDP indefinitely, reflecting Medicare and Social Security (i.e., pension) costs. This is clearly above the trend growth rate in nominal GDP, so US debt ratios will not stabilise in the long term. In contrast, EU and UK deficits are projected at about 4% and 2-3% respectively, levels that are similar to nominal GDP growth rates and therefore broadly consistent with stable debt ratios. While fiscal risks therefore seem greatest in the US, the reserve currency status of the dollar will delay the date when these risks could turn into a currency crisis for the dollar, which is the main channel through which inflation pressures could rise.
Public debt ratios have been allowed to increase markedly over time, in part because real interest rates have trended downwards for 40 years as “secular stagnation” has taken This has made higher debt burdens far easier to finance, without crowding out private investment. There is a growing risk that secular stagnation may reverse in the next decade, causing real interest rates to rise. If equilibrium real interest rates 9r*) rise above real GDP growth rates, government debt ratios could become unsustainable more rapidly than before, causing greater inflation pressure and (possibly) credit problems in the private sector, including in the financial sector. This would be the form that a modern public debt crisis might take.
There is no agreement among economists about the medium-term direction of equilibrium real rates. Several forces could push r* higher, including 1) ageing populations adding to public spending and reducing private savings; 2) higher defence spending; 3) the rising cost of measures to handle the climate crisis, including the extra investment needed to build green energy infrastructure; and 4) reduced excess savings in China. However, the impact of AI in boosting productivity growth may also have a large impact. In the very long run, this should increase r*. However, it might also lead to disinflationary pressure that might reduce real policy rates – and possibly real bond yields – for an intermediate period that could last many years. On balance, upward forces on r* might be expected to dominate, leading to more risk of debt problems, but these forces tend to work very slowly over extremely long periods.
The bottom line is that public debt crises do not seem imminent. If they begin to build, they will be reflected in inflation and currency pressures, not debt defaults in government bond markets. The US is more vulnerable than the EU to such problems but is protected by the dollar’s reserve currency status for the foreseeable future.
The Monetary Regime
What about the future of central bank inflation targets? There is no indication that either the Fed or (especially) the ECB is willing to consider an increase in the official 2% average inflation target in the next couple of Having made such large inflationary errors in 2021-22 they are now trying hard to prevent their mistakes from becoming embedded in long term inflation expectations and they would not want to risk dislodging these expectations by raising their official inflation targets. Furthermore, if they were to go down this path, they would only do so after a long public deliberation. Under the next Fed Chairman, when inflation is close to target, the FOMC might consider such a debate, but this will not happen soon. Meanwhile, the ECB would probably require a treaty change to allow any significant change in the target, which is highly improbable.
Having said that, it is important to bear in mind that both the Fed and the ECB have interpreted the timing of the path back to their inflation targets with a great deal of leeway since Provided that inflation is forecast to return to 2% within a 2–3-year forecast horizon, they appear willing to allow a lengthy overshoot in inflation in order to accommodate adverse supply shocks. Nor do they seem to think that the average inflation target requires a period of below-2% inflation to bring the average rate back to 2% after the current overshoot. This means there may be a permanent upward bias in actual inflation relative to targets.
In summary, the central banks are likely to retain their official 2% targets but interpret them in a very liberal manner to avoid deep recessions. The markets know all this, of course – which is perhaps why they are inclined to expect a soft landing rather than a deep recession in the next 12-24 months.