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The legacy
of pandemic debt
Will massive government spending and central bank easing lead to inflation, deflation or both?
The Covid-19 pandemic has led to severe supply shocks, business closures and layoffs. The first two factors usually mean higher prices, but layoffs and reduced economic activity constrain spending.
Amid these challenging conditions, central banks and governments around the world have committed to expenditures ranging from 8% to 20% of GDP, pushing public debt levels into the stratosphere.
What risks could result from such high debt levels, and what are the implications for investment policy today?
Learning from past pandemics
To glean insights into the possible economic conse- quences of Covid-19, a Federal Reserve Bank of San Francisco working paper examined the medium- and long- term effects of 15 pandemics, ranging from the Black Death in the 14th century to the 2009 H1N1 outbreak.
Figure 1 shows how the natural rate of interest responded after the pandemics ended (defined as a smoothed risk-free rate plus a high-quality bond return premium). The figure shows pandemics have been deflationary for decades following the event, while wars have been inflationary.
Figure 1: Response of the European real natural rate of interest following pandemics and wars
2 1
0 -1 -2
-3 0 10 20 30 40
Years after event
Source: Òscar Jordà, Sanjay R. Singh, Alan M. Taylor. 2020. “Longer-run Economic Consequences of Pandemics,” Federal Reserve Bank of San Francisco, Working Paper 2020-09.
Recessions are usually deflationary, because low out- put and low demand temper prices. The Federal Reserve Bank of St. Louis developed a measure to quantify the probability that the U.S. inflation rate will fall below zero. During 2008-2009, the probability rose only briefly. On
by Mark Yamada, president of PUR Investing Inc., a software development firm
April 30, the probability sat at 3.8%, but is estimated to move sharply higher as new statistics are released.
For instance, relief funding from the U.S. Coronavirus Aid Relief and Economic Security Act, plus announced bond sales, already exceed US$6 trillion and could push the country’s debt-to-GDP ratio to over 120% without tapering. Compare that to the ratio from 2008 through 2010, when three rounds of quantitative easing (QE) ele- vated the ratio from 60% to 100% by 2015.
Expanding credit: inflationary
Money supply growing faster than output tends to result in inflation. For the 20 years ended February 2020, including the US$4.5 trillion in QE from 2009 to 2014, the U.S. money supply grew by 6.2% annually while GDP growth was 3.9% per annum, a gap of 2.3%. The consumer price index, meanwhile, was 2.2% annually — pretty close to the gap.
Today, monetary authorities are stumped by what causes inflation. The inflation of the 1980s was the result of higher oil prices and increasing economic growth relative to the money supply, not money supply growth alone. The US$25 trillion in U.S. national debt today has funded fiscal spending in an unconstrained manner for decades — as has Canada’s $1.8 trillion without inflation. This relative debt would depreciate most currencies but the U.S. dollar remains the reserve. The loonie, mean- while, depends primarily on energy prices.
What next?
How likely is the economy to return to the pre–Covid-19 conditions of 2% inflation and 4% nominal GDP growth? It’s hard to say. Reorganizing supply chains to reduce dependence on China and India will take time and may be inflationary. More fiscal spending could also be inflationary.
But stimulus depends on how funds are administered. Businesses are unlikely to invest in capital spending with- out greater visibility and/or tax incentives. Consumers will be cautious until personal safety and employment cer- tainty are evident, so stimulus may be muted. As a result, post-pandemic deflation is likely.
If your clients are investing to achieve goals within the next two years, then selling to have the cash or holding short-term liquid instruments always makes sense. For longer-term goals, consider sectors that will grow through a deflationary environment, like technology companies. However, having cash in reserve makes sense until the nature of recovery is clear or there is another market washout. AE
     Consumers will be cautious until personal safety and employment certainty are evident, so stimulus may be muted
           Change in interest rate (%)
JUNE 2020

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