While investing heavily to fight the Epidemic is a natural choice for governments and central banks, economists are increasingly concerned that growing public debt will cause a major shock to markets.
Since the outbreak, organizations that have traditionally supported fiscal austerity, such as the OECD and IMF, have become much more tolerant of the trend of growing sovereign debt.
The view of these organizations is that as long as central banks keep interest rates at ultra-low levels, debt sustainability is not a major issue. With the current epidemic, the government should abandon its former restrictions (such as controlling the debt-to-GDP ratio) and focus on economic assistance, focusing on indicators such as interest payments as a percentage of GDP.
However, the above logic holds true based on a key assumption: Inflation stays low, allowing the central bank to continue to maintain low interest rates and massive asset purchases.
That said, if the inflation outlook is out of line with expectations, or even continues to rise, it will certainly force the Fed and other central banks to tighten monetary policy to balance inflation targets. Investors’ attention will then turn back to traditional indicators such as the debt-to-GDP ratio, thereby increasing financial instability.
What’s more, history tells us that not only interest rates and debt, but also any seemingly foolproof market rule, will one day be broken.
In the 1960s, governments were also convinced that there was a stable relationship between inflation and unemployment – the so-called “Phillips curve”. Politicians took it for granted that they could stabilize inflation and the job market simply by controlling this curve, depending on whether they preferred to protect jobs or control prices. But the economic stagflation of the 1970s showed that things were not so simple, and economists today are largely skeptical of the Phillips curve.
Another example is the Great Moderation of the 1990s and the first decade of this century.
At that Time, policymakers in advanced economies believed that they had permanent control over the business cycle turnover. Some even believed that central banks existed to set inflation targets, since this theoretically anchored expectations of price increases and prevented governments from overheating the economy.
But it turns out that there are other, more subtle factors that control inflation in rich countries, including globalization and the technological revolution. And the financial crisis and Great Recession of 2008 completely killed any notion that the economic cycle cycle was over.
Of course, there are many economists who claim that things are different this time and offer various explanations for why inflation will remain low for a long time.
These include: the moderating effect of technology on prices; the deflationary impact of an aging society; income inequality is limiting overall spending; and so on.
The market indications in the aftermath of the 2008 financial crisis, on the other hand, gave this group of economists the best weapon for debate.
At that time, central banks also took unprecedented stimulus measures, and critics were very concerned that this would trigger hyperinflation. In the end, however, inflation in the major developed economies was well contained at around 2%.
However, many of the laws of the market have failed in the aftermath of the outbreak, and no one can say whether low inflation will persist.
As demand surges, supply constraints continue to play a role, and companies try to rebuild profits, we could see inflationary pressures reappear.
In the Eurozone, for example, core inflation, which excludes volatile items such as Food and energy, jumped to 1.4% in January, the highest level in more than five years.
In the U.S., President Joe Biden‘s proposed $1.9 trillion stimulus plan has spooked some economists, including former Treasury Secretary Summers and former IMF chief economist Olivier Blanchard, who are concerned about the hyperinflation the plan could trigger.
In theory, inflation is not necessarily a bad thing for public debt. Accelerating prices help governments settle previously large debts because it pushes up taxes while the nominal debt remains the same. Countries will also benefit from the favorable debt structure they built during the deflationary period, including low interest rates, longer maturities and a large portion of sovereign debt held by central banks.
However, we cannot ignore the dynamics of financial markets. As inflation makes a comeback, it is not difficult to imagine that investors will rush to exit in order to avoid bond losses. If the deterioration of the debt-to-GDP ratio raises investor concerns, the situation could be dire.
After all, central banks can’t intervene more at this point – because they fear it will hurt the inflation targets they set for themselves.
Now, there are two things policymakers need to think about.
First, there is the rationale for government spending programs. As the epidemic rages on, politicians must do what they can to support their economies. Even if they have already introduced a vaccination program, the government should continue to provide help, especially to those families who have been hit the hardest.
However, as Italian Prime Minister-designate Mario Draghi said last summer, there are “good” and “bad” debts.
Some targeted, smart spending programs can go a long way toward raising a country’s long-term growth rate; but too much aid or spending money in the wrong places can backfire.
Second, central banks need to consider whether to adjust their views on inflation.
In the U.S., the Fed has made clear its willingness to tolerate a moderate level of inflation above 2% and the introduction of a so-called average inflation target, which may help alleviate market concerns about a sudden tightening of monetary policy.
For its part, the ECB is conducting a strategic assessment, and Lagarde needs to think about whether to look to the Fed.
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