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Is the National Debt Creating an Inflation Risk?

By Matt Shibata

As Congress has unleashed fiscal relief and the Federal Reserve has unveiled monetary support in response to the pandemic, we have received quite a few questions about whether inflation is coming and whether the growing national debt is cause for concern.

The short answer is that prices generally decline during recessions due to decreases in economic activity. Prices generally fall as business slows down, people lose jobs, and overall spending declines. There is a risk of inflation if the recession is so deep that it impairs the economy's ability to create goods and services (leading to shortages). For example, laptop prices should decline during a recession as manufacturers and retailers are forced to discount in the face of lower consumer spending (deflation). But if the recession is really deep (and enough suppliers, manufacturers, and retailers go out of business), then there may be a shortage of laptops in which case laptops will start selling at higher prices (inflation). We will certainly see inflation in certain goods and services, but we do not expect to see a meaningful increase in inflation.

As mentioned, several clients have asked whether increases in the national debt will lead to inflation. This requires a slightly longer answer. To combat the recession, Congress recently passed several rounds of fiscal relief, which means that they authorized the Treasury to spend money. For example, Congress has authorized the Treasury to provide additional unemployment benefits during this time, which allows many people to continue to buying food, paying rent, stay current on bills, and so on (and these peoples' spending is other peoples' income, so this spending by the Treasury percolates through the economy). 

This is where people start asking about where the money comes from, deficits, and the national debt. Although the Treasury could just create and spend dollars, it is required (by law) to "fund" its spending with tax revenue and debt. So if federal spending exceeds federal tax revenue, then the Treasury is required to "borrow" by issuing Treasury bonds. If the Treasury spends $1, it must also borrow $1 (by issuing Treasury bonds). So $1 goes out into the economy in the form of spending and $1 comes back in when it issues a Treasury bond (a loan that it accepts in dollars from the Treasury buyer). Government debt is created by government spending (and vice versa because they're two sides of the same coin) and the total amount of dollars in the economy is neither increased nor decreased. Thus, budget deficits and national debt are not concerns when it comes to dollars in the economy or inflation.

Of course, if the Federal Reserve creates dollars to buy Treasury bonds via quantitative easing (QE), then the amount of dollars in the economy is increased. While there are many debates about QE, it is important to note that most dollars are created by the banking system rather than by the Treasury. If a bank lends you $1M to buy a house, the bank will borrow this money from the Federal Reserve (which creates and credits the dollars to the bank's account at the Fed) and then lend it to you. Banks do have dollars from depositors, but their loans outstanding far exceed their depository bases so most dollars are created when banks lend. Since economic activity declines during a recession (and banks curtail lending), it is unlikely that many loans will be made (or dollars created). Consequently, we do not view inflation as a likely risk unless the economy is damaged to the point where we have widespread shortages (thereby driving prices up).