05.24.11
Spring 2011
Will mounting U.S. debt spark inflation?
Not if the Federal Reserve does its job. Granted, some Americans fear that the answer is "yes." They look abroad and see frightening evidence from some other nations with large fiscal liabilities. The government in Zimbabwe, to cite the most extreme example, recently used money created by its central bank to reduce the value of the nation's nominal deficit—a practice known as monetizing the debt. Money creation grew so rampant in Zimbabwe that at one point inflation skyrocketed to an insane monthly rate of 79 billion percent.
The risk that increases in federal debt could kindle inflation is far less pronounced in the United States, largely thanks to the Federal Reserve's independence. In establishing the Federal Reserve in 1913, Congress recognized the potential conflict between political demands and a central bank's long-term focus. For that reason, the Federal Reserve was designed to act independently within the government. Although Congress has ultimate oversight power over the Fed, it insulates the central bank, affording it flexibility in carrying out its dual mandate of price stability and maximum employment.
Historically, the Fed has maintained its focus on this mandate, even during periods of political unease, which should calm concerns that it might be bullied into inflating away the federal debt. Debt monetization implies a permanent increase in the money supply (see related FAQs), and there is nothing in the Federal Reserve's record to indicate that it would make increases permanent in response to lobbying. The early 1980s is a case in point: Paul Volcker's Federal Reserve refused to ease monetary conditions until inflation had been tamed, although the economy was suffering through a severe recession. More recently, Federal Reserve Chairman Ben Bernanke vowed that "the Federal Reserve will not monetize the debt," and emphasized the need for changes in fiscal policy to put government financing on a sustainable path.
Consider the importance of political independence in a more complicated scenario of debt monetization. In seeking buyers for its debt, the Treasury would increasingly find itself competing against private business for investors. The resulting bidding war would drive up longer-term interest rates, and each dollar going to finance public debt would "crowd out" private investment. This, in turn, would inhibit economic growth. Faced with higher interest rates and slower growth, a politically vulnerable Fed might be tempted to loosen monetary policy at the cost of inducing future inflation.
However, the risk of this development unfolding in the United States is limited. The Fed is politically independent and makes decisions based on long-term goals for inflation and employment. It would be violating its Congressional directive to keep prices stable if it let the money supply grow to the point of runaway inflation. Although nothing about public debt makes inflation inevitable, much is unclear about the impact of large fiscal deficits on the macroeconomy. Nobody knows the debt-to-GDP ratio that will prompt markets to begin putting significant upward pressure on interest rates. There is no magic number. Developed countries have reached higher debt-to-GDP levels than either current or projected U.S. levels, without experiencing high inflation.
The most notable example is Japan, which has a debt-to-GDP ratio of nearly 200 percent, far beyond even the most pessimistic medium-run projections for the United States. (This spring, the United States' reported debt-to-GDP ratio was around 62 percent.) Yet in Japan, the inflation rate during much of the past 15 years has been negative. The United States itself faced a significantly higher debt-to-GDP ratio after World War II, yet the next two decades were not marked by either high interest rates or high inflation (although the Fed's strategy for helping the federal government fund combat efforts did result in prioritization conflicts until an agreement was reached between the Treasury and the Federal Reserve).
Of course, in each of these examples, debt-holders' expectations were shaped by unique, case-specific factors. Clearly, some long-term decisions must be made to put the U.S. fiscal situation on a sustainable path. For now, demand for Treasury debt remains strong, and inflation expectations are well anchored. That's good news for those who worry about debt monetization and inflation. But beyond that, the Federal Reserve endures as a politically independent institution. Above all else, this should give the public confidence that even if public debt does add pressure to interest rates, the Federal Reserve will always strive to maintain price stability.