- Despite the Fed’s campaign against it, US inflation stands at 8.3% and is forecast to moderate only slightly when September’s figures come out on Thursday.
- For all the bad inflation does, it helps with one thing: reducing countries’ debt burdens. And the US government is currently $30tn in debt.
- Consequently, the Fed may accept higher inflation in the economy (say 3-4%, rather than the current 2% target) to reduce this burden.
- A change in thinking could mean the Fed halts its hiking cycle earlier than we expect.
- However, our core thesis remains for Fed hawkishness ahead, and a peak in interest rates of over 5%.
[Updated 14 October] The latest inflation data for the US came out on Thursday, giving investors an update on how successful the Federal Reserve’s campaign against it has been. So far, the Fed has struggled to tame price rises through its contractionary policies, with inflation for September at 8.2% and the wage-price spiral clearly worsening. Meanwhile, core CPI set a 40-year high, coming in at 6.6%.
Inflation can hurt all participants in an economy, from the government through to businesses and consumers.
For a start, price rises lump more pressure on the government to raise the value of the state pension, unemployment benefits and other welfare payments to mitigate the increasing cost of living.
For businesses, it increases costs – both inputs to their products and eventually the wages they must pay as staff demand raises to offset rising prices. It also knocks business confidence because firms cannot precisely anticipate future costs and demand for their products, prompting them to reduce their capital investment.
Real income falls also mean consumers have less purchasing power, which often entails a shift in spending habits – from discretionary items to essentials. And ultimately, they spend less for fear of further cost pressures in the future. This reduces demand across the economy.
Then there is the impact of negative real interest rates, which erodes the value of savings. And on the flip side, as financial markets look to protect themselves from inflation, they increase the cost of borrowing – from credit cards to mortgages.
With all that, you would be hard pushed to argue that inflation is a good thing, right?
But for all the bad it does, inflation may be good news for government finances. The US government currently has $30.9tn dollars in outstanding debt. In nominal terms, that is the largest amount borrowed in history, and as a share of GDP – at around 126% – close to the largest ever for the US. Even the Second World War saw the debt:GDP reach only 120%.
Inflation, however, has been one of the most common ways to reduce the debt burden of countries throughout history. This year is a case in point – the US debt:GDP ratio reached 133% last year, but this year it has fallen to 126%.
How could that be if the US is still running a fiscal deficit (i.e., still borrowing more)? The answer lies in that nominal GDP has gone up faster than the new borrowing. So while real GDP was only up 1.8% in Q2 versus the year before, nominal GDP is up a whopping 9.6% thanks to inflation. This is how inflation erodes the debt burden.
We are so used to low inflation environments we tend to forget the impact of high inflation on everything. With inflation, government debt dynamics look less perilous as debt is inflated away. With inflation, the real value of assets such as housing or even equities can fall without large nominal declines. And while there are social costs in high inflation as real earnings fall, it does provide a generational transfer of wealth from the old (long fixed income) to the young (longing for assets).
This makes me wonder whether the Fed and other central banks may ultimately come to accept 3% or 4% as an acceptable terminal level of inflation. If so, this could challenge our view that the Fed will hike more than the market thinks. For now, I still like to position for Fed hawkishness, but I’m keeping an eye on the allure of inflation to manage debt problems.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.