1. Taxation is a direct transfer from private sector to public sector with no gain in overall spending, so it is non-inflationary. In current circumstances, with Donald Trump as President and the Republican Party holding a majority in the Senate, it is highly unlikely that significant new taxes will be introduced to finance budget deficits. We therefore set aside taxation as a meaningful avenue for funding the imminent federal budget deficits and debt.
2. Borrowing is non-inflationary only if the funds are borrowed from real savings or asset pools at home and abroad. In principle this means selling new Treasury bill and bond issues to “real money” investors, but not to banks (see Figure 5).
In the domestic sphere “real money” investors include insurance companies, pension funds, mutual funds, US corporates and individual savers. Foreign “real money” buyers would include a diverse range of non-US savings institutions including but not limited to Asian insurance companies, European pension funds, sovereign wealth funds, and foreign central banks.
However, if the increased deficit is financed largely by selling the new debt to banks in the US, this will be potentially inflationary since it creates money. (Remember, it is money that creates inflation, not debt – look at Japan over the past 30 years.)
The reason is that, fundamentally, when a bank makes a loan it writes up the loan as an asset and simultaneously credits the deposit account of the borrower. Deposits are money so this creates new money. Similarly, when a bank purchases a security, it acquires a new asset, and simultaneously credits the deposit account of the seller (in this case the federal government).
This process was in operation in the US in 2019. With the doubling of the federal deficit to roughly $1 trillion (as a result of the tax cuts of 2018), and the Treasury switching funding tactics to issue many more T-bills, US banks bought significant amounts of US government securities, creating money, and in the process doubling the rate of M2 money growth from 4% to 8% p.a. This was the primary driver of the strong bull market in equities from September until February. If the boost to money and spending had continued and Covid-19 had not occurred, it was our forecast that nominal GDP and inflation would have been rising by late 2020 or early 2021.
It follows that in 2020-21 and beyond the US authorities will need to manage carefully the amount of bank purchases of government debt if they are to limit broad money growth, and hence avoid any inflationary consequences from the greatly enlarged Covid-19 deficits.
3. “Printing money” is a crude expression that has three possible interpretations.
First, as explained above for the US last year, substantial purchases of government securities by the banks can amount to money creation.
Second, “printing money” can result from a policy of either keeping market interest rates too low so that banks are encouraged to lend more than they otherwise would. Alternatively, in a fixed exchange rate regime (which does not apply for the US), keeping the exchange rate too low (i.e. undervalued), can generate a surplus on the overall balance of payments that produces an influx of funds from abroad. Both more lending and an inflow of funds from abroad create additional deposits (=money) on the liability side of bank balance sheets. In current circumstances we judge these possible outcomes as unlikely – at least for a year or two.
Third, “printing money” can mean central bank purchases of government securities in the primary market (buying bonds directly from the government) which is what we typically see in countries like Venezuela and Zimbabwe. However, in modern economies such practices are either specifically prohibited by law or prevented by means of independent central banks which are assigned mandates to keep inflation low. In summary, such crude “printing” of money is therefore unlikely, but the possibility cannot be completely ruled out. [Note that Quantitative Easing or QE in the US and the UK after the 2008-09 crisis was not a purchase of bonds directly from the government. Rather it comprised purchases of securities already held by the private sector – i.e. by “real money” investors.]
Evaluation of the Inflation Outlook
Although US bank lending, deposits, money supply (M2) and broad money (M3) have all grown rapidly since early March, we view this as primarily a once-for-all consequence of the drawdown of credit lines by US corporations. Out of a total increase in “Loans & Leases” of $600 billion in the same period, we estimate that approximately $400 billion was due to credit lines being activated. There is clearly huge uncertainty about the growth of lending or bank deposits over the next few months, but if after the liquidity squeeze of the current emergency personal and corporate behaviour is able to return to more normal patterns, the temporary monetary surge need not translate into inflation.
In the past it has always required an extended acceleration of money and credit growth to generate a significant shift in the pattern of inflation. For the present the huge increases in unemployment, the collapse in commodity prices such as oil and gas, and the widespread uncertainty about the future will likely translate into a deflationary environment in the short term. Only after the economy and employment have recovered and been on a recovery path for at least a year would inflation start to become an issue. If, by then, the growth rates of money and credit had slowed to more normal trajectories, then the impact on inflation could well be quite subdued.
All that we can confidently say at present is that the inflation outlook will depend heavily on the degree and duration of monetary acceleration over the next couple of years, which in turn will depend significantly on how the unavoidable, big budget deficits are financed.
John Greenwood is Chief Economist at Invesco.