William Diamond, Tim Landvoigt, and Germán Sánchez, authors of 2024 NBER Working Paper 32573, “The Mortgage Suppression: Fiscal Inflation and the Post-Covid Boom,” analyzed the impact on the economy of the massive fiscal and monetary stimulus implemented during the COVID-19 crisis—in response to the recession, the government implemented a series of programs that resulted in deficits of $3.1 trillion in 2020 and $2.7 trillion in 2021. Deficits in three next few years will have reached another $5 trillion ($1.4 trillion in 2022, $1.7 trillion in 2023, and estimated 1.9 trillion dollarsor 6.7% of GDP, in 2024).
Note that these massive deficits occurred despite the unemployment rate remaining at or below 4.0% (a level considered to be full employment) as of the end of 2021. Traditional economic theory suggests that at full employment fiscal policy should be in surplus. Looking ahead, the CBO's latest estimate calls for deficits to equal or exceed 5.5% of GDP annually through 2034. Here's a summary of their key findings:
A decrease in real rates (nominal rates minus inflation) stimulated consumption demand—a decrease in real rates induces consumers to substitute current consumption for future consumption. The stimulus provided by low real rates increased total economic output, causing a housing price boom that disproportionately affected homes owned by borrowers constrained (by their debt capacity).
Coordinated fiscal and monetary policy easing can provide a strong stimulus – after a generous fiscal stimulus, a temporarily loose monetary stance that allows for transitory inflation makes the stimulus more powerful.
The mix of loose fiscal and monetary policy provided a powerful economic stimulus, causing an increase in inflation, especially in house prices, which redistributed wealth from savers to borrowers (first by suppressing interest rates and then causing inflation) . Further, the incentive effect increases with the amount of outstanding household debt.
Fiscal transfers must either be supported by an increase in future taxes or be distributed immediately by inflation, with no real effects – if fiscal transfers were supported by expected future tax increases, there would be no inflationary effect. Inflation erodes the real value of nominal debt and is therefore redistributed from savers to borrowers, raising borrowers' consumption and house prices while reducing savers' consumption. Redistribution to borrowers results in a long-run reduction in output as borrowers reduce their labor supply.
The authors concluded that “Fiscal transfers outside of a recession must either be supported by future tax increases or inflated immediately. In a recession, fiscal stimulus causes post-recession inflation if the government commits not to raise future tax revenues. This post-recession inflation redistributes from savers to borrowers, increasing output and housing prices in the recession. The power of fiscal stimulus increases with the stock of outstanding household debt.”
Their findings are consistent with John Cochrane's “Fiscal theory of the price level”, the essence of which is that if future taxes are not enough to offset government spending (the deficit is unsustainable), inflation will rise because the government will eventually “inflate” the debt, reducing its real value.
People who lose faith in full repayment cause inflation as they anticipate this strategy. Thus, unsustainable government spending leads to inflation, not just the amount of money printed. This is an important problem for the US, as under a Trump or Biden presidency, it is likely that the US will continue to have a huge spending problem, with spending far outstripping revenue. And eventually, lenders may no longer be willing to finance deficits. If spending is not cut, the alternative solution would be to raise taxes at European levels. However, the result would be European-type growth rates, which have been much lower than ours. And that would have negative consequences for stocks.
Investor Relations
The findings of the study by Diamond et al. suggest that the government's response to the Covid crisis, while effective in stimulating the economy, may have long-term consequences. While inflation has been steady, the US has a huge spending problem that no political party seems willing to address. Given the projections of large fiscal deficits indefinitely into the future, economic theory suggests that we risk a much higher level of inflation in the long run than the market expects.
There are two ways to address these issues for investors concerned about volatility and downside risk. The first is to reduce exposure to stocks and long-term bonds and bonds with significant credit risks, while increasing their exposure to relatively safer short-term loans. By dramatically raising interest rates, the Fed has made that option more attractive than it has been in years. For example, for those concerned about inflation, THE yield on 5-year TIPS it has risen from about -1.6% in early 2021 to about 2% as of this writing.
Another way to address risk is to diversify exposure to include other unique sources of risk that have historically had little or no correlation with stock cycle risk and/or traditional bond inflation risk, but have also provided risk premium. Below are alternative assets that can provide diversification benefits. Alternative funds carry their own risks; therefore, investors should consult their financial advisors about their circumstances before making any adjustments to their portfolio.
Reinsurance: The asset class looks attractive, as losses in recent years have led to dramatic increases in premiums and terms (such as increased deductibles and tighter underwriting standards) have become more favorable. These changes led to returns well above historical averages in 2023. Investors may consider funds such as SRRIX, SHRIX AND XILSX.
Middle market private lending (especially senior, secured, sponsored, corporate debt): Prime lending rates have increased significantly, loan spreads have widened, lender terms have improved (origin fees have increased) and credit standards have tightened (tighter covenants). Investors can consider funds such as CCLFX AND CELFX.
Consumer credit: As credit risks have increased, lending rates have risen sharply, credit spreads have widened, and credit standards have tightened. Investors can consider funds such as LENDX.
Long-short factor funds. Investors can consider funds such as QRPRX AND QSPRX.
The goods. Investors can consider funds such as DCMSX.
The following trend (time series moment): It performs best when needed most during extended bear markets. Investors can consider funds such as QRMIX.
Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich your future: the keys to a successful investment