Chief China Strategist
"Persistent high inflation is always and everywhere a fiscal phenomenon." - Thomas J. Sargent
The COVID-19 pandemic has ushered in a period of unprecedented fiscal and monetary responses in the United States. The subsequent economic landscape has been characterized by significant government spending, high levels of debt, and persistent inflation. Drawing on the works of Hall and Sargent, this article argues that inflation is fundamentally a fiscal phenomenon, exacerbated by current fiscal dominance that resembles the post-World War I and II periods but with notable differences. It explores why inflation is likely to be persistent, the compromised independence of the Federal Reserve (Fed), and the implications for US Treasuries.
Inflation is often debated in terms of monetary policy, yet fiscal policy plays a crucial role. The COVID-19 pandemic has seen massive fiscal expenditures, similar to the surges during World War I and II. However, this time the fiscal strategy is notably different.
As illustrated by Hall and Sargent (2022a, 2022b), the US “War on COVID-19” shared important features with World War One (WWI) and World War Two (WWII).
According to Hall and Sargent, 3.0% and 8.5% of the US population left the economy to be in active military service in WWI and WWII, respectively, while 7% of the working-age population was on unemployment benefits during COVID-19. In all three cases, the economy was hit by a sudden fall in labor supply due to the government drafting the working-age population to fight in the wars or being put out of work due to lockdowns.
During the world wars, military conflicts and resource diversion caused significant trade disruptions. Similarly, the COVID-19 pandemic led to widespread supply chain issues globally due to lockdowns, labor shortages, and transport bottlenecks, affecting the US economy. Both crises saw travel restrictions and border closures to control movement and mitigate impacts, further disrupting economic activities.
Similar to the two world wars in the twentieth century, US federal government expenditures surged sharply during the COVID-19 pandemic in 2020/21. Figure 1 below, adapted from Hall and Sargent (2023), shows that federal outlays net of interest payments as a percentage of GDP surged to as high as over 20% in WWI, nearly 40% in WWII, and around 35% during COVID-19.
According to Hall and Sargent (2023), the US federal government spending during WWI was 74.6% financed by issuing interest-bearing debts, 20.8% by taxes, and 7.0% by increasing the monetary base. During WWII, 46.0% of the federal government spending was funded by interest-bearing debts, 30.2% by taxes, and 10.1% by increasing the monetary base. However, during COVID-19, there were three major differences from the two World Wars.
First, taxes only funded 4.0% of the federal government spending, much below the 20%-30% in the two World Wars. Second, 45.1% of the federal spending was funded by the Fed increasing the monetary base, followed by 38.1% by the Treasury issuing debts. In the two World Wars, interest-bearing debts issued by the Treasury accounted for most of the effective borrowing. This brings us to the third difference: most of the additional monetary base created by the Fed was interest-bearing reserves and reverse repos. Therefore, for the bulk of the monetary base creation, it was not seigniorage that the Fed created money from thin air but the Fed effectively borrowed from banks in the form of interest-bearing reserves and from money market funds in the form of interest-bearing reverse repos. In Figure 2, the Fed has dramatically increased the amount of reserves and reverse repos since early 2020 while the increase in the coins and notes in circulation has been much smaller.
While the Fed bought bonds in all three incidents—WWI, WWII, and COVID-19—the Fed incurred interest costs for funding these purchases, unlike during the World Wars when the Fed did not pay a dime on banks’ reserve balances at Federal Reserve Banks and did not borrow from money market funds with reserve repos. As of June 12, 2024, the Fed is paying interest rates of 5.4% p.a. on $3.88 trillion bank reserves and 5.3% p.a. on $0.39 trillion reserve repurchase agreements with money market funds and federal agencies (excluding foreign official and international accounts) (H.4.1). This amounts to over $200 billion a year in interest costs to the Fed. The $4.46 trillion US Treasury securities are providing interest income at only 1.9% p.a. on average, much lower than the 5.4% and 5.3% that the Fed is paying on bank reserves and reverse repos to fund these holdings. In other words, the Fed is losing money in this huge carry trade by a negative carry of 340 to 350 basis points. The cumulated operating loss of the Fed reached $160.4 billion by the end of Q1 this year (Fed Quarterly Financial Report) . If not for the peculiar accounting treatment of the cumulated losses as a deferred asset in the logic that the losses can be used to offset the Fed’s future obligation of remittances to the Treasury, this loss would have more than wiped out the $43.1 billion capital of the whole Federal Reserve system. Furthermore, the cumulated mark-to-market loss in the Fed’s Treasuries portfolio was $635.8 billion. When including the unrealized loss of $410.8 billion from the $2.4 trillion mortgage-backed securities which yield 2.23% p.a., the total unrealized loss on the Fed’s balance sheet as of March 31, 2024, for its securities portfolio was $1.05 trillion.
Despite the widely perceived image of independence, the Fed is effectively an extension of the fiscal authority of the US federal government. Most of the monetary base increase created by the Fed during the COVID-19 was effectively federal debt.
As shown in Figure 1, after WWI and WWII, federal government outlays net of interest payments fell below receipts for some years, producing primary surpluses that contributed to the paydown of the federal debts. This eventually helped reduce the wartime debts. As seen in Figure 3, federal debt held by the public as a percentage of GDP declined.
However, this time, the US federal government has no plan to return to primary surpluses. The US federal debt as a percentage of GDP has continued to increase since the end of the COVID-19 pandemic and is projected by the Congressional Budget Office (CBO) to continue climbing over the next 10 years.
In Figure 4 below, the CBO projects a total deficit of 6.9% and a net of interest payment primary deficit of 2.7% in 2034 and an average of 2.5% primary deficits throughout the 10 years leading to 2034.
This raises alarms among economists about the implications of persistent high inflation. As Adam Smith remarked in the Wealth of Nations, “A prince, who should enact that a certain proportion of his taxes be paid in a paper money of a certain kind, might thereby give a certain value to this paper money.” In other words, the value of fiat money is backed by the US federal government’s capability to tax. Economists such as Cochrane (2021) argue that the real value of government debt equals the present value of future primary surpluses. As the US government is projected to run primary deficits for a long period into the future, it will be potentially at risk of causing persistent inflation. This is because when the present value of cumulative future primary surpluses falls, it reduces the government’s capability to pay back its debts and, therefore, the value of the fiat money that the government issues. For the value of fiat money to fall, the price level must adjust upward, causing persistent inflation.
After the massive increases in deficits from the federal government, the Consumer Price Index (CPI) rose to as high as 9.1% year-over-year in June 2022 and then declined to 3.3%. The Core Personal Consumption Expenditures (core-PCE) index, the Fed’s preferred inflation gauge, advanced to 5.6% and then fell to 2.8%. Investors are hopeful that the decline may continue and fall towards the Fed’s 2% target. However, the projected persistent deficits in the federal government’s primary fiscal balances cast doubts on this thesis.
As illustrated in Figure 1, in the post-war years of the two World Wars, the US federal government resumed running primary surpluses for some years. Accompanied by economic growth, the debt-to-GDP ratio fell. Even so, inflation persisted for several years. According to Hall and Sargent (2023), the US CPI increased cumulatively by more than 70% between 1914 and 1919 and still remained 55% higher than in 1914 after the 1920-21 Great Depression. In the case of WWII, the CPI increased cumulatively by around 55% from 1939 to 1946, even though the rise was postponed by price and wage controls imposed during the war (Figure 5).
Given that the US federal government is projected to continue running a primary deficit, unlike in the post-war years of the two World Wars, it is reasonable to conjecture that the price level may have to adjust upwards by at least as much as 55%, similar to the post-war years, seven years after the start of the war on COVID-19. Since the headline CPI increased by 21.1% from January 2020 to May 2024, the subsequent rise in inflation from now to December 2027 could be 7.1% per annum. Using core PCE for the 55% increase in seven years, the subsequent annual inflation rate from now to the end of 2027 could reach 8%. These are not forecasts but conjectures of possible scenarios. If the price level were to adjust as much as in the two post-war eras, inflation would likely rebound persistently in the coming years given the persistent primary fiscal deficits and the lack of credible plans from the US fiscal authorities to fund these deficits through a combination of reduced outlays and increased taxes.
The experience from the two twentieth-century world wars does not bode well for bond investors amidst persistent primary fiscal deficits in the US, arguably putting them in a worse situation than in the two post-war periods. The potential for a rebound in inflation would harm investors holding long-duration bonds, in nominal as well as in real terms, particularly the latter. The following chart (Figure 6), adapted from Hall and Sargent, illustrates the alarming losses in real terms for $100 invested in a value-weighted, rebalanced portfolio of all outstanding US Treasury securities.
In conclusion, the economic landscape post-COVID-19 shares striking similarities with the fiscal and monetary conditions during and after WWI and WWII, particularly in terms of government spending, fiscal deficits, and inflation. However, there are also significant differences, especially in how the Fed has financed these deficits. The lack of a credible plan of the US federal government to return to primary surpluses further exacerbates the inflationary pressures and poses risks to long-duration bondholders.
This analysis does not constitute investment advice or make specific forecasts. It is merely an attempt to draw informed conjectures based on historical experiences during periods when labor, trade, transportation, and production were disrupted, and the US federal government faced large fiscal deficits. These reflections are intended to inspire further thought and discussion.
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