Inflation expectations will determine the success of the US stimulus package

Thanks largely to low interest rates, the US’s stimulus package is fiscally manageable. Fiscal restraint will be required however, to ensure it remains so.

The US not only has old-fashioned cheques (checks), but checks in the post (mail) nogal. No fewer than 90 million cheques worth $1,400 each have been mailed so far to Americans earning less than $400,000, with more to come. The dollars will find their way out of the Federal Reserve Bank (Fed) into individual banking accounts, or cashed in, which will add to both bank deposits and the cash reserves of the banks with the Fed. Deposits with US banks are up by 26% since January 2020 and the cash reserves of US banks are up by 92%. Both represent huge firepower for additional spending on goods and services, and bank lending over the next year.

US growth in cash reserves of the banking system and growth in bank deposits

Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment

The debt-to-GDP ratio will rise to over 130% and the fiscal deficit will soon approach 30% of current GDP. But interest rates remain exceptionally low – the average interest paid on all US debt is only 2% a year and interest payments account for 9% of all federal spending. In 1990, interest payments accounted for 23% of the federal budget at an average interest rate on the debt of about 10%. In short, these are now comfortable fiscal conditions. These ratios improved appreciably in the 1990s, thanks to lower deficits. The borrowing requirements of governments can and indeed have to be restrained by some mixture of spending less and taxing more – both hard to do. Another $3 trillion of US government spending on so-called infrastructure is coming down the pike. There will be no fiscal crisis for the US on the horizon, if US borrowing costs remain low. But can they?

Average interest paid on US debt and Interest paid as a percentage of all Federal government spending

Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment

It will depend on how much inflation is expected over the next 10 years. The higher the expectation of inflation, the higher the cost of raising government debt will be. Interest rates rise with higher inflation expectations in an almost lockstep way. The expected annual inflation rate over the next 10 years in the bond market is of the order of an unthreatening 2.2%. The higher the cost of borrowing, the more likely governments may resort to printing more money to fund their spending, which in turn will reinforce spending and increase the rate of inflation (and raise expectations of inflation).

All will depend on the scale of US borrowing expected over the next 10 years. It will have to slow down to something like normal to prevent the US Budget from being overwhelmed by higher interest rates. Janet Yellen, the Treasury Secretary, told Congress that taxes will have to rise to pay for the extra $3 trillion. Will they, or will the unpopular prospect of higher taxes restrain spending ambition? It will take more than taxing the rich to pay the piper.

US ratio of Federal government debt and fiscal deficits to GDP

Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment

US Federal government deficits

Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment

Fed Chairman Jerome Powell is relaxed about inflation for now and he remains determined to help the US economy get back to full employment. He is waiting to see what will happen and he believes he has the tools to dial inflation back should it rise temporarily – as is widely expected.

So what are these tools? Mainly, it is the power to control short-term interest rates by adding or taking away dollars from the system. He does not however control how much the government spends, how much it taxes and how much it will have to borrow. The higher he sets short-term interest rates, of course, the less popular he will become. His political independence should not be taken as a permanent given.

Powell is confident that inflation is well anchored around the current 2% annual rate, the Fed target for inflation. Actual inflation however depends on expected inflation and on the difference between actual GDP and potential GDP – the output gap. Powell believes the Fed has this gap under control. But without active co-operation from fiscal policy to restrain government spending over the long run, this inflation anchor could easily slip away. As with the Fed, we will wait and watch.

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