ABOUT THE AUTHORA member of Putnam's Fixed Income team since 2007, Onsel Gulbiten analyzes macroeconomic issues, including inflation, interest rates, and policy developments.
As inflation sticks around, it is important to think about how it is related to high government debt.
- Debt has risen ever since the global financial crisis (GFC) in 2008, with increases from the tax cuts in 2017–2018 and the massive Covid response of 2020–2021.
- The Federal Reserve's efforts against inflation so far have not caused rising unemployment or financial instability.
- As tightening continues, central banks might face a trade-off between inflation and a debt crisis.
The U.S. debt problemThe public debt-to-GDP ratio was around 60% before the 2008 GFC and the related recession. This deep downturn that unavoidably increased debt was later followed by procyclical fiscal policies during an expansion. Then, Covid arrived. A large fiscal stimulus was followed once again by expansionary policies when the economy was already recovering with vigor. As a result, the U.S. debt is today about 120% of GDP, and this does not include future Social Security and Medicare obligations of the U.S. government.
When debt surged after the GFC, a quiet financial repression took place — governments and central banks suppressed interest rates and helped reduce the debt stock. The private sector deleveraged, and the Fed implemented QE, keeping the real rate on U.S. Treasuries paid to finance the deficit below the real growth rate. This helped slow the rise of the government debt-to-GDP ratio, although it did not reverse the direction. Inflation and growth remained low, and the fiscal policymakers did not see any urgency to actively reduce debt. Thanks to private sector deleveraging, inflation remained low.
Financial repression eased debt burdens after World War II and the GFC
U.S. debt, budget deficit, and interest rate-growth gap (%)
Sources: Bloomberg, Bureau of Fiscal Service, Bureau of Economic Analysis, Congressional Budget Office.
In the later stages of the last cycle, which ended with the Covid pandemic, governments' willingness to take advantage of low interest rates was rising. As an example, U.S. fiscal policy turned accommodative in 2017–18. The Fed tried to withdraw accommodation but made a U-turn when financial assets sold off in late 2018.
Adding to this buildup of debt, in the wake of Covid, both monetary and fiscal policymakers tried to solve the virus problem with money. When the constraints on spending were lifted but stimulus stayed, inflation emerged. The Fed eventually recognized the inflation problem and tightened policy in a rush. So far, this has not caused a problem for employment or financial stability.
More generally in the post-GFC world, leaving aside the self-inflicted eurozone crisis, the surge in developed market (DM) indebtedness did not become a problem, largely because of abundant liquidity. Central banks significantly increased their balance sheets. Thanks to the private sectors' willingness to hold DM debt at low yields — as well as demographic trends supporting higher savings — inflation stayed low. Central bankers did not face a trade-off.
How debt, demographics, and yield demand changeTimes have changed. The demographic trends that enhanced consumers' willingness to save, resulting in lower rates and supporting lower inflation, have stopped being supportive (though they are also not an impediment yet in most countries). The retirement tide is just turning, and public pension programs, which are largely pay-as-you-go systems, still have positive net assets and are investors in Treasury markets.
Comparison of debt in major economies since 1900
Major economies — debt-to-GDP Ratio (%)
Source: International Monetary Fund.
The debt issue needs to be addressed, but neither in the U.S. nor in any other major economy has there been willingness to cut government spending and efficiently raise taxes. When governments are unable or unwilling to raise taxes or reduce spending, inflation becomes the optimal choice. Inflation transfers spending power from taxpayers to the government, serving as a form of taxation (that is also inefficient).
Historically, there is a negative relationship between inflation and government size relative to GDP
Government size (% of GDP) and inflation (%, Y/Y)
Sources: Organisation for Economic Co-operation and Development, World Bank.
Context changes central banks' dilemmaCentral banks have shifted their attention to inflation and started reducing their balance sheets, but liquidity is still high. The Fed, the ECB, and many others have significantly larger balance sheets today than before Covid, while the BoJ has not even started tightening yet. Real rates governments are facing today are still relatively low.
However, if liquidity continues to be withdrawn through QT and rates hikes, at some point, global liquidity might be tight enough for private sector investors to demand higher yields, complicating the already deteriorating debt arithmetic. If central banks then ease policy quickly, inflation is likely to stay. Will the central banks maintain their independence to kill off inflation, or will they stop tightening, keeping liquidity and inflation “relatively” high?
The trade-off between debt markets and inflationPursuing price stability might be the key responsibility of a central bank, but maintaining market functioning through its role as the lender of last resort is another, and it predates the price stability goal. Larger central bank balance sheets have increased the banks' roles in maintaining the smooth functioning of government bond markets, key pillars of financial markets. Central banks may not directly choose to live with higher inflation for the sake of maintaining lower unemployment or avoiding a recession, but the imperative to keep a larger balance sheet, so as to maintain financial market stability, is likely to result in relatively higher inflation. Central banks may not admit or even conceive that they might be becoming a financing vehicle, but when government indebtedness is high and political willingness to restore fiscal discipline is low, inflation tax is the second-best policy option.
In the U.S. and other major DM countries, inflation will be coming down further in the coming months. This is due partly to monetary tightening and partly to the normalization of supply chains, labor markets, and the global economy as the pandemic effects fade. The underlying inflation in the new steady state will emerge once one-offs fully wane.
Falling global inflation might deceive many, but in a new world where household willingness to consume is greater than before the Covid pandemic while liquidity is relatively high, inflation is likely to stay above pre-pandemic levels. So long as there are hopes for genuine disinflation, neither society nor the Fed appears ready to take the most painful medicine.
Moreover, given the context of high debt and declining liquidity, if the Fed manages to return inflation to 2% by tightening sufficiently, real effective yields will be higher than real GDP growth, which will complicate debt dynamics. It likely means an unpleasant debt crisis is ahead of us.
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