Will public debt lead to rocketing inflation and interest rates?

We’re living through quite a transformation in attitudes toward deficit spending and the accumulation of public debt.

In Canada, the federal government just brought down a budget that projects a $154.7-billion deficit this fiscal year after running up a staggering $354.2-billion shortfall last year to fight the pandemic. In the budget, the government announced over $100 billion in new spending over the next three years.

In the U.S., the federal government is headed toward a US$2.3 trillion budget deficit in 2021, according to the non-partisan Congressional Budget Office. On top of $4 trillion in pandemic-related stimulus in 2020, the Biden administration is adding all this year’s $1.9 trillion COVID relief package to the national debt.

It’s a similar story in other countries around the world where governments are running high deficits to combat COVID and support an economic recovery. Central banks, for their part, are pumping liquidity into economies by maintaining low interest rates and bond buying programs.

In Canada, many in the baby-boom generation and older will remember the effort in the mid-1990s to wrestle the deficit under control with draconian spending cuts. Those memories are often tied up with painful recollections of an era of high inflation and punishing interest rates in the 1980s and early 1990s.

For a quarter of a century after the successful fight against the deficit, Canadians took pride in the fiscal restraint that led to Canada consistently having the lowest debt-to-GDP ratio in the G-7. Balanced budget laws became all the rage.

Now, many may be wondering if we could be heading back to a high inflation, high interest rate environment and an untenable public debt situation. Before we tackle the likelihood of that scenario, let’s look at what’s changed over the last quarter century.

First and foremost, inflation and interest rates have trended steadily downward, reducing public debt servicing costs. In fact, as you can see in this article, Canada’s public debt charges are at a historic low, despite the recent run-up in deficits.

Second, there has been a virtual consensus among policymakers and economists that government stimulus spending in response to the 2008-09 financial crisis was too timid, leading to a long, sluggish recovery. Governments were determined to not let that happen again in the COVID crisis, regardless of the short-term impact on the national debt.

Third, it appears policymakers have become increasingly enamoured with modern monetary theory (MMT). It observes that a federal government budget is not like your household budget. The difference is that the federal government can finance its spending with money created by the central bank. MMT posits that deficits are sustainable as long as the economic growth they generate isn’t so strong that demand outstrips capacity, sparking high inflation. This line of thinking seems to be loosening government purse strings in Canada, the U.S. and Europe.

For investors, the key question is whether all this government spending combined with strong economic growth will spark runaway inflation and a spike in interest rates and/or higher taxes to control it.

Clearly, inflation is trending higher in the short run. The Bank of Canada now expects it to rise by to close to 3% in the coming months, then settle back to around its 2% target, before starting to climb again in 2023 to 2.3%. The bond market has already reacted to the prospect of moderately higher inflation, with interest rates picking up in recent months.

Over the longer term, there isn’t a clear link between government debt on one hand, and inflation and rising interest rates on the other. In Canada, debt-to-GDP peaked during the Second World War period, but inflation remained muted until the 1970s. A look at historical interest rates in Canada shows that spikes in the 80s and 90s were unique in history.

Inflation is a complex phenomenon, but the aging population appears to be an important deflationary factor. Indeed, in recent years, the focus of central banks has been more on preventing deflation and the accompanying spiral of negative consequences.

The bond market is currently expecting inflation over the next 30 years will average 1.7% per year in Canada and 2.2% per year in the U.S. This is up from a low reached in March 2020 of 0.8% and 1.3% in Canada and the U.S., respectively. So, the bond market is expecting an uptick in inflation ahead but hardly a runaway surge in prices over the long run. If inflation did begin to ratchet up more than expected, central banks have a tool kit to fight back. ¹

As for Canada’s national debt, it remains the lowest in the G-7 as a percentage of GDP and is still well below levels reached in the early 90s and in the Second World War period. Ottawa says it will fall to 49.2% of GDP in 2025-26 from 51.2% this year. (It’s well over 100% in the U.S. and over 260% in Japan.)¹

With vaccination programs gathering steam and the economy set to grow strongly, the best advice on inflation, interest rates and the national debt is to stay calm and carry on. We’ll see how the long-term data evolves before getting too worried.

¹ Long term bond market inflation expectations are measured by taking the difference in yield between the 30-year nominal government of Canada bond yield minus the long term government of Canada real return bond yield, as quoted on the Bank of Canada website.