- Budget deficits and inflation are separate but often confused issues.
- Inflation is a "monetary phenomenon" where too much money sloshes around the economy relative to available goods and services.
- Deficits are a "fiscal" result of government expenses exceeding revenues.
- The two are discrete but can be related.
Kind of like Goldilocks and the Three Bears, we don't want our monetary policy too cold or too hot—we want it just right. Not too many months ago, folks feared deflation—where dollars are scarce and prices fall. In fact, in some regions of the world deflationary results are cropping up, but in aggregate today, those fears seem remote. Now, there's a new bugaboo to fixate on: High inflation as a result of unprecedented money supply growth in the last months. Even more, folks fear ballooning budget deficits will stoke coming inflation. True, higher inflation could happen down the line—say a couple years from now when capacity utilization and money velocity recover. But lumping budget deficits and inflation together can be a mistake.
Inflation is a "monetary phenomenon" with too much money sloshing around in the economy (the mirror of deflation), where extra dollars can't be absorbed by economic activity, chasing prices in aggregate higher. The Fed has two proclaimed mandates: To monitor employment and inflation. On the inflation side, the Fed is charged with keeping just the right amount of money in the economy so dollars aren't too hard to find, but also not so abundant that prices rise sharply. It uses its many tools—interest rate targets, open market operations—to make the monetary porridge just right. Lately, with the velocity of money decelerating and credit markets tighter, temporarily increasing liquidity in a big way has been a good and helpful thing for capital markets.
What does that have to do with deficits? Normally not much. Budget deficits result when government expenses exceed normal revenue sources like taxes—this is "fiscal" policy. Governments shuffle money around the economy, taking cash from one group and giving it to others. It's redistribution rather than straight money creation. It only adds to money supply if the central bank chooses to "monetize" the debt by printing money to cover the difference.
At present, the Fed's additions to its balance sheet (money creation) haven't been ostensibly to finance the deficit, but to provide liquidity and relieve financials firms of illiquid (rarely traded) and/or distressed assets. However, some "monetizing" of the deficit is surely taking place as well.
But it's still monetary policy, not the deficit in and of itself, that increases (or decreases) money supply. Investors should keep budget deficits and inflation separate in their minds because deficits don't necessarily lead, step for step, to inflation. Understanding this will go a long way in trying to parse the Fed's monetary policy in the months and years ahead. Should investors be fretting inflation? Not yet—as we've said before, inflation can't be a concern until producers have pricing power again—likely a ways off. And the Fed has numerous ways to measure inflation and mitigate it as necessary. We'll have to wait and see what they do about it when the appropriate time arises to take that extra liquidity out of the system.