With growth so uncertain, it is understandable that central banks would be wary of beginning to taper monthly bond purchases before it is clear that inflation has taken off. But they would do well to recognize that prolonging quantitative easing implies significant risks, too.
Inflation readings in the United States have shot up in recent months. Labor markets are extremely tight. In one recent survey, 46% of small-business owners said they could not find workers to fill open jobs, and a net 39% reported having increased their employees’ compensation. Yet, at the time of this writing, the yield on ten-year Treasury bonds is 1.24%, well below the ten-year breakeven inflation rate of 2.4%. At the same time, stock markets are flirting with all-time highs.
Something in all this does not add up. Perhaps the bond markets believe the US Federal Reserve when it suggests that current inflationary pressures are transitory and that the Fed can hold policy interest rates down for an extended period. If so, growth – bolstered by pent-up savings and the additional government spending currently being negotiated in Congress – should be reasonable, and inflation should remain around the Fed’s target. The breakeven inflation rate also seems to be pointing to this scenario.
But that doesn’t explain why the ten-year Treasury rate is so low, suggesting negative real rates over the next decade. What if it is right? Perhaps the spread of the COVID-19 Delta variant will prompt fresh lockdowns in developed countries and damage emerging markets even more. Perhaps more nasty variants will emerge. And perhaps the negotiations in Congress will break down, with even the bipartisan infrastructure bill failing to pass. In this scenario, however, it would be hard to justify the stock-market buoyancy and breakeven inflation rate.
One common factor driving up both stock and bond prices (thus lowering bond yields) could be asset managers’ search for yield, owing to the conditions created by extremely accommodative monetary policies. This would explain why the prices of stocks (including “meme stocks”), bonds, cryptocurrencies, and housing are all a little frothy at the same time.
To those who care about sound asset prices, Fed Chair Jerome Powell’s announcement last week that the economy had made progress toward the point where the Fed might end its $120 billion monthly bond-buying program was good news. Phasing out quantitative easing (QE) is the first step toward monetary-policy normalization, which itself is necessary to alleviate the pressure on asset managers to produce impossible returns in a low-yield environment.
The beginning of the end of QE would not please everyone, though. Some economists see a significant downside to withdrawing monetary accommodation before it is clear that inflation has taken off. Gone is the old received wisdom that if you are staring inflation in the eyeballs, it is already too late to beat it down without a costly fight. Two decades of persistently low inflation have convinced many central bankers that they can wait.
And yet, even if monetary policymakers are not overly concerned about high asset prices or inflation, they should be worried about another risk that prolonged QE intensifies: the government’s fiscal exposure to future interest-rate hikes.
While government debt has soared, government interest payments remain low, and have even shrunk as a share of GDP in some countries over the last two decades. As such, many economists are not worried that government debt in advanced economies is approaching its post-World War II high. But what if interest rates start moving up as inflation takes hold? If government debt is around 125% of GDP, every percentage-point increase in interest rates translates into a 1.25 percentage-point increase in the annual fiscal deficit as a share of GDP. That is nothing to shrug at. With interest rates normally rising by a few percentage points over the course of a business cycle, government debt can quickly become stressful.
To this, thoughtful economists might respond, “Wait a minute! Not all the debt has to be rolled over quickly. Just look at the United Kingdom, where the average term to maturity is about 15 years.” True, if debt maturities were evenly spread out, only around one-fifteenth of the UK debt would have to be refinanced each year, giving the authorities plenty of time to react to rising interest rates.
But that is no reason for complacency. The average maturity for government debt is much lower in other countries, not least the US, where it is only 5.8 years. Moreover, what matters is not the average debt maturity (which can be skewed by a few long-dated bonds), but rather the amount of debt that will mature quickly and must be rolled over at a higher rate. Median debt maturity (the length of time by which half the existing debt will mature) is therefore a better measure of exposure to interest-rate-rollover risk. Sign up for our weekly newsletter, PS on Sunday
More to the point, one also must account for a major source of effective maturity shortening: QE. When the central bank hoovers up five-year government debt from the market in its monthly bond-buying program, it finances those purchases by borrowing overnight reserves from commercial banks on which it pays interest (also termed “interest on excess reserves”). From the perspective of the consolidated balance sheet of the government and the central bank (which, remember, is a wholly owned subsidiary of the government in many countries), the government has essentially swapped five-year debt for overnight debt. QE thus drives a continuous shortening of effective government debt maturity and a corresponding increase in (consolidated) government and central-bank exposure to rising interest rates.
Does this matter? Consider the 15-year average maturity of UK government debt. The median maturity is shorter, at 11 years, and falls to just four years when one accounts for the QE-driven shortening. A one-percentage-point increase in interest rates would therefore boost the UK government’s debt interest payments by about 0.8% of GDP – which, the UK Office for Budget Responsibility notes, is about two-thirds of the medium-term fiscal tightening proposed over the same period. And, of course, rates could increase much more than one percentage point.
As for the US, not only is the outstanding government debt much shorter in maturity than that of the UK, but the Fed already owns one-quarter of it. Clearly, prolonging QE is not without risks.
Policymakers should be cautious about adding more to the national debt and the money supply.
The sharp increase in consumer prices this spring may be a blip but may also be a sign that inflation is returning as a chronic problem. For those of us who can accurately recall the 1970s economy, it is a frightening prospect. Everyone else would benefit from reading contemporaneous news coverage.
Recent events call into question pronouncements of the leading Modern Monetary Theorists who thought that the U.S. could sustain much larger deficits without triggering major hikes in the cost of living. Instead, it appears that the traditional rules of public finance still hold: deficit spending financed by Federal Reserve money creation is inflationary.
Analogies between today’s situation and the 1970s are not quite on target. By the early 70s, inflation was well underway. Instead, we should be drawing lessons from the year 1965, when price inflation began to take off. Prior to that year, inflation seemed to be under control with annual CPI growth ranging from 1.1 percent to 1.5 percent annually between 1960 and 1964 — not unlike the years prior to this one.
Like 2021, the post-election year of 1965 saw the inauguration of an ambitious unified Democratic government. That year, Congress enacted Medicare and Medicaid, began providing federal aid to local school districts, and greatly expanded federal housing programs. At the same time, the Johnson administration was expanding U.S. involvement in Vietnam, increasing the defense budget. The federal budget deficit expanded from $1.6 billion in the 1965 fiscal year (which ended on June 30 in those days) to $27.7 billion, or 3% of GDP, in fiscal 1968.
Although the Federal Reserve made some attempts to ward off inflation, it generally accommodated the government’s fiscal policy according to Allan Meltzer’s detailed history of this period published by the St. Louis Fed. Between calendar years 1965 and 1969, annual CPI growth surged from 1.6 percent to 5.5 percent, setting the stage for the Nixon administration’s closure of the U.S. Treasury’s gold window and imposition of wage and price controls. Inflation reached double digits in 1974 and again between 1979 and 1981. Notably, these were also recession years, refuting the fallacy of the Phillips Curve, which depicted a supposed policy trade-off between inflation and unemployment. By the early 1980s, we had ample evidence that ill-considered policies could give us a combination of high inflation and unemployment, known back then as “stagflation.”
This policy mix was also not great for equity investors. The Dow Jones Industrial Average moved sideways during the inflationary period, closing at the same level in December 1982 as it did in January 1966. One lesson from that period was that high interest rates can be bad for stocks.
That may be one reason the Fed remains reluctant to allow interest rates to rise today. Although messaging from the latest Federal Open Market Committee meeting showed greater willingness to normalize interest rates, action is not expected until 2023.
Rate hikes may bring other worries for the Fed in today’s environment. Given the large volume of variable rate mortgages and corporate loans outstanding in the U.S. today, a rise in interest rates could push highly indebted homeowners and companies into bankruptcy, potentially triggering a recession. The federal government would have to roll over its record stock of short-term debt at higher interest rates, ballooning its interest expense and potentially crowding out more popular spending priorities.
But if private capital is to continue participating in debt capital markets, such as those for corporate bonds and bank loans, interest rates will have to rise to compensate them for the loss of purchasing power on their principal.
Although annual growth in CPI fell sharply after 1982, it is not strictly correct to say that inflation was defeated. Except for a few years around the turn of the century, the federal government continued to run deficits, a portion of which were monetized. Notably, the government began running trillion dollar deficits, and the Fed drove interest rates down to near zero during the Great Recession, but CPI growth remained muted.
But CPI does not tell the whole story. Some sectors of the economy have experienced substantial inflation, but they are not fully incorporated in the consumer price index. Home prices, healthcare costs and college tuition all soared in recent decades. Meanwhile, apparel and consumer electronics remained affordable due to globalization and improved technology.
Back in the 1970s, most of the world was not part of the global economy. Eastern Europe was in the Soviet bloc, while China, Vietnam and India had yet to become major exporters. As more low-cost producers of goods and services came online during the 1980s and 1990s, prices were pushed downward (often and regrettably at the expense of American manufacturing jobs). The trend toward developing countries joining the international trading system and producing inexpensive consumer goods is now over. Indeed, the recent increase in protectionism is, if anything, rolling back the wave of international price competition.
On the other hand, technological improvements may continue to shield us from inflation in certain sectors. For example, the displacement of human cashiers by automated check stands might restrain price hikes at the big box retailers, supermarkets, fast food chains and other establishments that can afford to invest in them. Smaller businesses, facing higher wages, may have to try to pass them through to consumers in the form of higher prices. Already in some parts of the country, restaurants are trying to recoup costs without raising prices on their menus by adding various surcharges ostensibly tied to specific costs.
It is possible that inflation is now moving from assets and human-intensive services to consumer products, but we will need several months of additional data to know for sure. Meanwhile, policymakers should be cautious about adding more to the national debt and the money supply.
The specter of inflation haunts Joe Biden’s presidency
Treasury Secretary Janet Yellen got into trouble Tuesday for telling the truth. That morning, at a conference sponsored by the Atlantic, she raised the possibility that one day the Federal Reserve may raise interest rates “to make sure our economy doesn’t overheat.”
Anyone with a basic understanding of economics knew what she was talking about. The combination of President Joe Biden’s gargantuan spending and the accelerating economic recovery may well lead to a rise in consumer prices and hikes in interest rates. But an end to the Federal Reserve’s program of easy money would hurt asset prices and possibly employment as well.
Which is not what most investors want to hear. When Yellen’s words reached Wall Street, the market tanked. By the afternoon she was in retreat, telling the Wall Street Journal CEO summit that she had been misunderstood. “So let me be clear,” she said. “That’s not something I’m predicting or recommending.”
No, of course not. But it still might happen anyway.
A specter is haunting the Biden administration—the specter of inflation. Past inflations have not only harmed consumers, savers, and people on fixed incomes. They have also brought down politicians. Among the risks to the Democratic congressional majority is a rise in prices that lifts inflation to near the top of voters’ concerns, coupled by the type of Fed rate increase that hits stocks and housing. Inflation is one more signpost on the road to Republican revival, along with illegal immigration, crime, and semi-closed public schools embracing far-left critical race theory.
The classic definition of inflation is too much money chasing too few goods. That might also describe America sometime soon—if not already. The economy has started its post-virus comeback. Jobs and growth are on the upswing. U.S. households sit on a trillion-dollar pile of savings. Over the last year, on top of its regular spending, the federal government has appropriated a mind-boggling amount of money: a $2 trillion CARES Act, a $900 billion COVID-19 relief bill, and a $2 trillion American Rescue Plan. And President Biden wants to spend about $4 trillion more.
Surging this incredible amount of cash into an economy that is rapidly approaching capacity may have unintended and harmful consequences. But the Biden administration is either unconcerned about inflation or afraid of bringing it up in public.
Why? Well, one reason is that earlier warnings, after the global financial crisis in particular, didn’t seem to come true. (The inflation may have shown up in the dramatic ascent in prices of stocks and bonds, as well as in odd places such as the market for high-end art.) Another reason is that some economists think a little bit of inflation would be a good thing. But the main explanation may be related to status-quo bias: Inflation hasn’t been a driving force in our economic and public life for decades, and so we blithely assume it won’t be in the future.
Which is why an experienced leader worries about repeating the mistakes of the past. And yet, for a politician who came to Washington in 1973, Joe Biden has a lackadaisical attitude toward inflationary fiscal and monetary policy. Was he paying attention? It was the great inflation of the ’60s and ’70s, caused in part by high spending, the Arab oil embargo, and spiraling wages and prices in a heavily regulated and unionized economy, that helped ruin the presidencies of Gerald Ford and Jimmy Carter.
Inflation led to bracket creep, with voters propelled into higher income tax brackets by monetary forces over which they had no control. And bracket creep inspired the tax revolt, supply-side economics, and the Reaganite idea that, “In this present crisis, government is not the solution to our problem; government is the problem.” The eventual cure for inflation was the painful “shock therapy” administered by Federal Reserve chairman Paul Volcker and what at the time was the worst recession since the Great Depression.
Why anyone would want to repeat this experiment in the dismal science is a mystery. Biden, however, is fixated not on inflation but on repudiating the legacy of the man known for describing it as “always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Milton Friedman, whose empiricism led him to embrace free market public policy, was the most influential economist of the second half of the 20th century. But Biden has a weird habit of treating Friedman as a devilish spirit who must be exorcised from the nation’s capital. For Biden, Friedman represents deregulation, low taxes, and the idea that a corporation’s primary responsibility is not to a group of politicized “stakeholders” but to its shareholders. “Milton Friedman isn’t running the show anymore,” Biden told Politico last year. “When did Milton Friedman die and become king?” Biden asked in 2019. The truth is that Friedman, who died in 2006, has held little sway over either Democrats or Republicans for almost two decades. But Biden wants to mark the definitive end of Friedman and the “neoliberal” economics he espoused by unleashing a tsunami of dollars into the global economy and inundating Americans with new entitlements.
The irony is that Biden’s rejection of Friedman’s teachings on money, taxes, and spending may bring about the same circumstances that established Friedman’s preeminence. In a year or two, the American economy and Biden’s political fortunes may look considerably different than when Janet Yellen blurted out the obvious about inflation. Voters won’t like the combination of rising prices and declining assets. Biden’s experts might rediscover that it is difficult to control or stop inflation once it begins. And Milton Friedman will have his revenge.