Inflation risk from COVID-19 fiscal policy

Chas Craig, BridgeTower Media Newswires

The fiscal and monetary policy expansions that have come about during the COVID-19 crisis have caused some to worry anew about the prospect of spikes in inflation. An inflation spike is probably not a short-term risk given the contraction in aggregate demand we’re experiencing from the COVID-19-induced recession, which is very unlikely to fully snap back in a v-shaped fashion. However, it does seem reasonable to consider the prospects for meaningfully higher inflation than the Fed’s 2% annual target over the medium to long-term, even if the double-digit inflation seen in the 1970s is a remote risk.

Regarding fiscal policy and the buildup of national debt, a well-entrenched theme that has only been turbo-charged by COVID-19, common sense tells us that any entity, even the most powerful nation the world has ever known, can’t borrow money ad infinitum without negative consequences, the question is only the degree of severity. Also, despite what the tenets of Modern Monetary Theory state, common sense dictates that government deficits and the resulting debt can’t be monetized via Fed purchases of Treasury obligations in increasing amounts without causing an inflationary impulse at some point. However, it does seem likely that the limits of both fiscal and monetary policy are much higher than I and others thought reasonable a decade ago. The fact that inflation and yields on long-term U.S. Treasury bonds remained subdued during a time of significant national debt buildup and easy monetary policy in the post-Financial Crisis period is an indication of this likelihood.

However, over the medium to long-term, I’m in general agreement with the inflationary concerns stoked by the multitrillion-dollar-and-counting fiscal response to the virus and the massive expansion of the Fed’s bond buying programs. To be clear, I’m not stating that these policies were ill-advised, only that interventions of the magnitude that have occurred are going to have consequences, some positive and some negative. My concern isn’t so much that I have a high level of conviction that inflation will spike, but that the market seems very certain that it won’t. To this point, the difference between 30-year nominal and inflation protected Treasury bonds, a rough estimate of the market’s expectation for average inflation over the period currently registers at roughly 1.5%, a level well below the Fed’s stated target of 2%.

Also, while concerns over debt monetization are explicitly regarding inflation, many jobs being created and the exacerbated mental health issues that have boiled up during this period are implicitly inflationary, all else equal. Point being, a contact tracer does not add to the productive capacity of the economy. They may help maintain the existing capacity if people feel safer to get out of their homes, but they don’t add to it. The result is a reduction in productivity, which is inflationary, all else equal. Decreased mental welfare is also an obvious detriment to worker productivity.

In closing, I’m reminded of a chemistry experiment gone bad at my high school many years ago when people waive away the risk of an inflation shock to financial markets on the premise that it simply hasn’t happened despite many of the things being in place we learned in our economic textbooks were supposed to cause it. In the chemistry experiment, the student mixed the prescribed amount of chemicals to cause the expected reaction, but nothing happened. So, the teacher advised the student to pour more, still nothing. Of course, more chemicals were mixed and then ... let’s just say a very expensive hand surgery ensued. Let’s hope the “dismal science” of economics doesn’t have an analogous episode.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).