Coronavirus and the Economy: Understanding Inflation Dynamics

This year, the United States could spend more than $12 trillion without causing serious inflation. For starters, the United States has the "exorbitant luxury" of holding the world's reserve currency. That is the currency that central banks around the world keep in large amounts to use if they need to prop up their own currency on foreign exchange markets or pay the country's international debt.

Since the dollar is the reserve currency, it is also used to price and pay for the majority of internationally traded resources, including oil and minerals, as well as illegal drugs and arms. Of course, such central banks and foreign traders do not necessarily store dollars in a vault. Instead, they use them to purchase U.S. Treasury bonds, which pay interest and can be easily converted back into dollars by selling them in the Treasury market. And, by purchasing all of these bonds, they lower the interest rate at which the Treasury will borrow, enabling the US to run large and permanent trade and fiscal deficits without experiencing a drastic drop in the value of its currency.

However, not only central banks are interested in purchasing Treasury bonds these days. Global equity and bond investors seek shelter in Treasury bonds during times of crisis. Fortunately for us, a spike in demand has occurred just when the Treasury is about to launch trillions of dollars of new bonds for them to purchase. This dynamic is already evident in global financial markets. The dollar has risen sharply, while Treasury bond interest rates have fallen to record lows. And central banks are now so desperate for dollars that the Federal Reserve has set up special programs to exchange newly printed dollars for other currencies.

The underlying explanation for all of this — why the dollar is the world's reserve currency and the US remains a financial safe haven — is that our economy remains the world's biggest, most profitable, and most resilient. Most of this is due to the confidence that the rest of the world has in our public institutions. A competent government will monetize debt in order to stabilize an economy during a once-in-a-century pandemic. It is not acceptable to routinely monetize debt in order to prevent difficult decisions by political leaders.

Some may be concerned that even though the Fed purchases the new bonds, taxpayers would be on the hook for the annual interest payments as well as the entire $2 trillion when the bonds mature. Even that, though, is a ruse.

The majority of people have a rather personal viewpoint on the nature of debt. We know that high levels of household debt and deficit spending are unsustainable. Household debt must be repaid at some stage. If a family is unable to do so, its debt must be renegotiated. It is safe to assume that the same is true for governments. However, this “government as a household” comparison is, at best, incomplete. The comparison fails for many reasons.

Debt Issuance

A household has a limited lifetime, while the government has an infinite planning horizon. So, unlike a household, which must ultimately pay off its debt, a government can, in theory, refinance (or roll over) its debt indefinitely.

Yes, debt must be repaid as it matures. However, maturing debt may be replaced with new debt. Running over the debt in this way guarantees that it will never have to be "paid for." Indeed, it can also rise over time in relation to the size of the economy's operations as calculated by population or GDP.

Unlike personal debt, the national debt is mostly made up of marketable securities such as bonds issued by the United States Treasury. It's worth noting that the Treasury Department sold some of its securities in the form of small-denomination bills known as United States Notes from 1862 to 1971, which are almost identical to the currency issued by the Federal Reserve today.

U.S. Treasury securities exist mainly as electronic ledger entries today. These securities are widely used as a form of wholesale money in financial markets. A large corporation's cash management division, for example, may tend to keep Treasury securities rather than bank deposits since the latter are only covered up to $250,000.

If cash is required to satisfy an obligation, the security may be sold or used as collateral in a short-term loan known as a "sale and repurchase agreement," or repo for short. Treasury securities trade at a premium to other securities because investors trust their liquidity. Thus, investors are willing to carry Treasury securities with relatively low yields, just as they are willing to carry insured bank deposits with very low interest rates, or securities with zero interest, such as the ones shown above.

Finally, the federal government controls the procurement of the country's legal tender. Since the gold recall in 1933, both of the above notes have been legal tender. Consider that the national debt is made up of U.S. Treasury securities that are redeemable in legal tender. Consider the national debt to be made up of interest-bearing variations of the U.S. Note shown above.

When the interest is due, it may be paid in legal tender, i.e. by printing more U.S. or Federal Reserve Notes. As a consequence, a technological default will occur only if the government approves it. The condition is analogous to a company funding itself with debt convertible to equity at the issuer's discretion. Involuntary default is almost difficult to reach. 3 This feature of US Treasury securities makes them highly attractive for investors seeking protection, which drives down their yields relative to other securities.

Debt as Currency

To the degree that the national debt is kept in the domestic private sector, it reflects domestic private sector capital. The degree to which it constitutes net wealth is debatable, but there is little doubt that some of it is perceived in this light. The implication is that rising the national debt makes people feel richer.

When this “wealth effect” is created by a deficit-financed tax cut (or transfers) during a recession, it can help stimulate private consumption, benefiting all. When the economy is at or near full employment, however, such a strategy is more likely to raise prices, resulting in a redistribution of income.

These considerations mean that we should examine the national debt from a different angle. It is more accurate, in fact, to interpret the national debt as a form of money in circulation rather than a form of debt.

Investors regard the securities that form the national debt in the same way that individuals regard money: as a medium of trade and a stable store of wealth. In this context, the notion of trying to repay money that is already in circulation makes no sense. Of course, not having to think about repaying the national debt does not mean that there is nothing to worry about. But, if the national debt is a form of income, where is the problem?

Debt Service

Treasury securities, unlike previous U.S. Bonds, pay interest (or sell at discount, in the case of Treasury bills). So, even though the national debt does not have to be repaid, it must be serviced. The carry cost is the interest rate associated with bearing debt.

Corporate activities tend to have a heavy impact on debt management techniques used by government treasury departments. Corporations, on the other hand, must worry about rollover risk, while governments can still rely on their central banks to fund refinance operations (if they so desire). Furthermore, businesses serve a smaller number of voters than the federal government. Given these factors, it is unclear if corporate debt management guidelines extend to the Treasury Department.

A bank, for example, may be used as an analogy in the business sector. A large portion of bank debt is in the form of protected deposit liabilities. Investors are able to hold deposits at low yields because insured deposits are secure and because they represent assets. As a result, deposits are a relatively inexpensive source of financing for banks.

This low-cost source of capital is used to hold higher-yielding assets such as mortgages and business loans. In this case, one could argue that the net carry cost of debt is negative. To the degree that the federal government invests in productivity-enhancing projects (e.g., healthcare and infrastructure), the same may be said for the national debt, which is readily borne by taxpayers at comparatively low yields.

Even if government expenses do not produce strong monetary returns, the federal government can be able to bear its debt at an effective negative rate. This would be valid, for example, if the average interest rate on the national debt was less than the rate of economic growth, or, in more technical terms, if r g.

Simple arithmetic dictates that if r g, the government will run a primary budget deficit indefinitely—that is, the effective carry cost of the debt is negative, even if the interest rate on the debt is positive.

5 Figure 1 plots the nominal GDP growth rate year over year against the five-year Treasury constant maturity rate.

Monetizing the Debt

The composition of the federal debt, which includes cash, reserves, bills, notes, and bonds, influences the average interest rate. Monetary policy influences the composition of the debt in part. When the Federal Reserve purchases Treasury securities, it is effectively exchanging lower-yielding assets for higher-yielding Treasury securities (a process known as "monetizing the debt"). The demand for currency determines the composition of Federal Reserve liabilities between deposits and currency in circulation, which can be thought of as a zero-interest government security.

The recent rise in Federal Reserve holdings of Treasury securities is mainly manifesting itself as interest-bearing deposits. As a result, private banks now hold vast amounts of interest-bearing deposits that, to a first approximation, are not much different from interest-bearing Treasury securities. As a result, debt "monetization" is no longer the same as it was in the past (see figure below), when Federal Reserve obligations mostly took the form of zero-interest securities (currency).

The government's ability to run a primary deficit (say, relative to GDP) is determined by the debt-to-GDP ratio. The government does not calculate the debt-to-GDP ratio; it is calculated by market demand for debt, which is determined by the structure of interest rates, which is determined or affected by the Federal Reserve.

A rise in debt clearly boosts the numerator of the debt-to-GDP ratio. However, how the debt-to-GDP ratio reacts is also influenced by the denominator. It is likely, for example, that an increase in debt causes the price level to rise even further, causing nominal GDP to rise and the debt-to-GDP ratio to fall for a given level of real GDP.

For a given price level (or inflation rate) and interest rate structure, there is presumably a limit on how much the market is willing or able to bear in the form of Treasury securities. However, no one knows exactly how high the debt-to-GDP ratio will rise. We won't know until we arrive.

Inflation

Nominal wealth's buying power is inversely proportional to the price level. That is, as prices increase, one's money buys less goods and services. The rate of change in the price level over time is referred to as inflation.

It is important to distinguish between a rise in the price level (a temporary change in the rate of inflation) and a change in inflation (a persistent change in the rate of inflation). It is admittedly difficult to differentiate between these two definitions in real time, but the distinction must be made.

The amount of nominal government "document" that the market is willing to absorb for a given price and interest rate structure is presumably limited. A one-time rise in debt supply that is not balanced by a related increase in demand is likely to result in a change in the price level, interest rate, or both. Continuous debt issuance that is not balanced by a corresponding rise in debt demand is likely to result in a higher rate of inflation. How the interest rate on US Treasury securities is influenced is primarily determined by Federal Reserve policy.

There is little reason to be worried about a rising national debt as long as inflation stays below a tolerable level. The risk of involuntary default is never a problem for a corporation that funds itself with convertible debt.

Of course, a company that uses its conversion option is likely to see equity dilution. Similarly, a government that uses its power to monetize debt is likely to see a price rise.

However, in both situations, the resulting dilution is more likely to be due to the underlying events that triggered the option rather than the conversion itself. A business or government that finds itself unexpectedly under fiscal strain (for example, due to an emerging competitor or a war) will have to deal with that pressure in some way, whether by cost-cutting steps, outright default, or dilution.

Inflation Target

Since 2012, the Federal Reserve has set an official inflation target of 2%. In a recent analysis of their monetary policy process, Fed officials stated that they were willing to let inflation exceed their goal if it meant accommodating an improving labor market.

However, the issue of what will happen if inflation increases to and stays above a tolerable level remains. At some point, the Federal Reserve may be forced to reduce its purchases of US Treasury securities, putting upward pressure on bond yields of all maturities.

Higher interest rates would decrease private sector wealth and raise borrowing costs, all of which would reduce private sector investment and delay economic growth. It will also increase the government's carrying expense. This, in turn, could lead to a slew of government austerity measures, sending the economy into a tailspin.

Of course, all of this may be avoided if the rate of debt issuance were slowed ahead of time. However, as previously mentioned, there is no way to predict how high the national debt will become until inflation becomes an issue.

After the 2008-09 financial crisis, the inflation rate for Personal Consumption Expenditures (PCE) has averaged about 1.5 percent. For the time being, what we can claim is that inflationary pressures tend to be contained. However, it will be prudent for the government to have a mechanism in place to deal with this contingency if it arises. As tax-and-spend legislation is rebalanced, the plan will cause inflation to remain elevated for a period of time.

COVID-19 Pressures

The recession caused by the COVID-19 pandemic varies from those caused by monetary-fiscal contractions or asset-price crashes in several respects. In these latter situations, private sector investment continues to fall even more than any shift in underlying fundamentals can justify. The COVID-19 shock, on the other hand, triggered a contraction in some sectors of the economy that served a specific social purpose: preventing the virus's spread.

A fundamental shock in one sector can, by definition, cause changes in the level of economic activity in others. While some sectors might even grow, total net production is expected to fall. To the degree that this reorganization of operation is a desirable response to the pandemic shock, fiscal stimulus aimed at increasing overall aggregate demand is not necessary.

A shock of this magnitude, on the other hand, disrupts and typically tightens credit conditions. An unpredictable economic outlook inevitably causes individuals and companies to cut back on expenses in order to save for the future. If this fear becomes self-fulfilling, some fiscal stimulus might be in order.

Even if fiscal stimulus is not required, it appears clear that social security is required. A program designed to sustain the wages of individuals and companies that have been disproportionately impacted by the pandemic is something that most people would want for themselves if they were so afflicted. To the degree that gross production falls and income support is funded by a one-time increase in the national debt, the price level is likely to rise.

In other words, Americans should brace themselves for a brief spike in inflation. To be sure, a higher price level is not unavoidable, as much depends on how demand for US Treasury securities reacts in the future.

However, if the inflation rate abruptly rises, it is not a warning to tighten monetary or fiscal policy as long as the rise is temporary. The higher price level that would follow this occurrence can be viewed as a tool for redistributing purchasing power over the course of the pandemic.