Inflating your way out of a hole ....and possibly straight into an even bigger one


ref :- "Inflation offers an escape route" by Irwin Seltzer , Business Section in The Sunday Times

Crushingly high rates of inflation certainly capture the headlines when they occur ...... and one of the many reasons why they should be newsworthy is that in the more developed nations they have become comparatively rare things of late. The odds are that most younger readers will never have encountered inflation rates that have seriously affected their existence or standard of living. Those of an older vintage, however, will have unhappy memories of the scourge of high inflation, and they will probably find it distinctly odd to talk about the benefits of higher rates of inflation in any sense.

But in one specific area -- that of national debt -- inflation can offer the government in question a helping hand (unless and until things get out of hand, that is) even if it's bad news for individuals. Inflation reduces the value of outstanding debt simply by reducing the value of money. It also increases the tax-take as wages grow ..... almost inevitably it takes time for governments to raise tax thresholds in line with inflation (the so-called "fiscal drag").

Take the US ..... mainly because where it leads the world tends to follow but also because when it comes to debt, the numbers are becoming truly spectacular. The whole world must be aware of the huge tax cuts introduced by this administration and the effect they're having in increasing government borrowing. Not too many seem to be fully convinced by the assertion that the fall in the tax-take will be more than made up for by the increase in tax income that will be the result of a fast-growing economy. And if you were tempted to think that the Democrats taking charge of the House of Representatives might put a brake on spending, think again ..... the Democrats are just as keen to boost spending on infrastructure as the current administration. They also support the mooted idea of tax cuts for the middle-income brackets. As Mr Seltzer points out, everyone's got a plan to spend and reduce taxes, but no one is proposing increases in other taxes to pay for it. The "math" is pretty simple ..... less tax income for the government and more spending = more borrowing.

For the reasons stated above, the temptation for politicians when faced with huge amounts of debt is to let inflation rise (by printing money). That, of course, prompts central banks to hike short-term rates, and will also force yields on longer bonds to rise as investors require larger returns to buy them ..... rising inflation is particularly bad news for bonds as their return (or interest) is fixed. Higher US rates and yields have global ramifications on growth, on the dollar, and as we have already seen spells particular trouble for emerging markets hit with the double-whammy of dollar-denominated debt.

We've been faced with the prospect of much higher yields for some time now, but though the 10yr Treasury yield has doubled since the lows of mid-2016, at 3.07% it is still very low historically-speaking and actually approaching the bottom of the recent trading range. The timing of Mr Seltzer's article may turn out to be ironic if yields really do take a lurch lower, but plainly he's talking of longer-term dangers. So how realistic are they ? Well, look at the numbers :

------ The annual budget deficit in 2018 is set at $779 billion, and due to hit $1 trillion next year (double the figure for 2017) and in all foreseeable years thereafter.

------ The total US debt mountain has risen from $5 trillion to $16 trillion in a decade (not including intra-governmental debt of a further $5 trillion).

------ In two years time, the interest cost alone will exceed the bill for Medicare. In 2023, it will exceed the current defence budget (itself greatly expanded). By 2025, interest payments will exceed all other expenses.

------ If there is a recession between now and 2025 (and most pundits think there will be), the drop in government revenues will exacerbate the situation.

The question posed by Mr Seltzer is : with those kind of numbers in mind, do you really think that an annual return of just over 3.0% on a 10yr Treasury (and 4.76% on a 30yr mortgage) is a realistic reflection of the risk to investors ?

Now, President Trump's election promise was to pay off the national debt in eight years (which now leaves him just six). He has now agreed to work with the Democrats on the size of the debt and other budgetary matters. Of course, in order to do so, he would require them to play ball by dropping any demands for inquiries into a number of matters relating to his affairs and conduct. Given the different agendas of the two parties, and the open hostility between the President and a large rump of Democrats, how likely is any of this to happen ?

"Not very" is the likely answer, but unless the politicians agree on some kind of sensible spending restraint, the prospect of them tackling the debt problem by allowing inflation to climb becomes more real.

There is an alternative, more optimistic scenario however ..... that growth exceeds the official forecasts of an average of 1.7% per year between 2020 and 2026, and the resulting increased revenues alleviate the problems in government finances. To subscribe to that view takes a fairly large leap of faith, and it's not one that most commentators would be prepared to make. It's certainly the view often put forward by Mr Trump, and in fairness, to the man he is full of surprises. But on this ? With the stakes so high ? Mmmm.....

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