Will Expanding Fed Balance Sheet, Govt Bailout Bring Inflation?

Vito J. Racanelli

There’s been a lot of hoo-ha over the efforts of the Federal Reserve, the Treasury and Congress, all spending trillions of dollars to help the economy and markets stabilize and recover. But let’s spare a thought for those who think this spending, regardless of its good intentions, is excessive and counterproductive. Heresy, you say. Well, read on.

In The Wall Street Journal Thursday, Tim Congdon, chairman of the Institute of International Monetary Research at the University of Buckingham, England, is flat out worried about inflation. I’ll summarize here.

The Fed has poured money into the economy at the fastest rate in the past 200 years in an effort to prevent a collapse in the quantity of money, which caused the Great Depression. Unfortunately, this overreaction could turn out just as poorly; history suggests the U.S. will soon see an inflation boom, he writes. Deposits at U.S. banks have risen 6% in just three weeks, the fastest rate since the Revolutionary War. The problem now becomes financing the much-enlarged budget deficit.

Congdon thinks the deficit could hit $3 trillion and others say $4 trillion. To a large extent the gaps will be financed by the banking system, with monetary financing of the budget deficit adding to the amount of money in the economy.

It’s reasonable to assume that by spring 2021 the quantity of money will have increased by 15%, he says, and possibly by as much as 20%, outpacing previous peaks in the inflationary 1970s. Federal expenditures are rising sharply while tax revenues are being hit by the lockdown. Both World War I and World War II—and, indeed, the Vietnam War—were followed by nasty bouts of inflation. If that happens again, policy makers today being cheered for their swift, decisive action will instead have to answer for their grave lack of foresight. I can’t disagree.

Others do. Greg Ip of the WSJ noted that this year’s budget deficit should hit $3.8 trillion, or 18.6% of gross domestic product, the highest since 1945. Debt could hit 106% of GDP in 2022, matching the record set in 1946, he wrote. But he pooh-poohs the usual worry of resulting inflation. The boost to the debt from coronavirus stimulus is being offset by lower interest rates. In a debt crisis, investors worry the debt reaches levels the country may be unable to repay. They refuse to buy its bonds, sending interest rates sky high, which simply adds to the burden of the debt.

But right now, the opposite is happening, Ip argues. Five years from now, markets expect the fed-funds rate will be just 1%, half of what it expected in early 2019, according to Cornerstone Macro, an investment firm.

In early March, the CBO predicted the debt would be 89% of GDP in 2025 and interest on that debt would cost about 2% of GDP. CRFB now projects the debt will be 107%, yet interest will still be just about 2%. The Fed’s target federal-funds rate is effectively zero, and 10-year Treasury yields are below 1% for the first time. Don’t expect this to quickly reverse when the pandemic is over, Ip contends.

It might not be a quick reversal, but it will reverse, I think. Inflation could be coming.

The yield on the benchmark 10-year U.S. Treasury note was 0.59% vs 0.65% one week previous.

Upcoming FOMC meeting on April 28-29. Expect talk not action.

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Vito J. Racanelli
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