William Diamond, Tim Landvoigt, and Germán Sánchez, authors of the 2024 NBER Working Paper 32573, “Printing Away the Mortgages: 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 range of programs resulting in deficits of $3.1 trillion in 2020 and $2.7 trillion in 2021. Deficits in the following three years will have totaled about another $5 trillion ($1.4 trillion in 2022, $1.7 trillion in 2023, and an estimated $1.9 trillion, or 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) since the end of 2021. Traditional economic theory suggests that at full employment fiscal policy should be in surplus. Looking forward, the CBO’s latest estimate calls for deficits to equal or exceed 5.5% of GDP annually through 2034. Here is a summary of their key findings:
The reduction in real rates (nominal rates minus inflation) stimulated consumption demand—a reduction in real rates incentivizes consumers to substitute present consumption for future consumption. The stimulus provided by low real rates increased total economic output, causing a boom in house prices that disproportionately impacted houses owned by constrained (by their debt capacity) borrowers.
Coordinated easing of fiscal and monetary policy can provide strong stimulus—after a generous fiscal stimulus, a temporarily loose monetary stance that permits transitory inflation makes the stimulus more powerful.
The mix of loose fiscal and monetary policy provided powerful economic stimulus, causing a surge in inflation, especially in housing prices, that redistributed wealth from savers to borrowers (first by suppressing interest rates and then causing inflation). Further, the stimulative impact increases with the amount of outstanding household debt.
Fiscal transfers either must be backed by an increase in future taxes or are immediately dissipated by inflation, with no real effects—if the fiscal transfers had been backed by expected future tax increases, there would not have been the inflation impact. Inflation erodes the real value of nominal debt and, therefore, redistributes from savers to borrowers, increasing borrower consumption and house prices while reducing saver consumption. The redistribution to borrowers results in a longer-term reduction in output as borrowers reduce their labor supply.
The authors concluded that “Fiscal transfers outside of a recession either must be backed by future tax increases or are immediately inflated away. In a recession, fiscal stimulus causes inflation after a recession if the government commits not to increase future tax revenue. This post-recession inflation redistributes from savers to borrowers, increasing output and house prices in the recession. The power of fiscal stimulus grows with the stock of outstanding household debt.”
Their findings are consistent with John Cochrane’s “The Fiscal Theory of the Price Level,” the gist of which is that if future taxes aren’t sufficient to offset government spending (the deficit is unsustainable), inflation will rise because the government will eventually "inflate away" the debt by lowering its real value.
People losing faith in full repayment triggers inflation as they anticipate this strategy. Thus, unsustainable government spending leads to inflation, not just the amount of money printed. This is a significant problem for the U.S. as under either a Trump or a Biden presidency, it is likely that the U.S. will continue to have a huge spending problem, with expenses running way above revenues. And eventually, lenders may no longer be willing to finance the deficits. If spending is not cut, the alternative solution would be to raise taxes to 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 equities.
Investor Takeaways
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 residing, the U.S. has a major spending problem that neither 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 term than the market is currently expecting.
There are two ways to address those issues for investors concerned about volatility and downside risk. The 1st is to reduce exposure to stocks and longer-term bonds and bonds with significant credit risks, while increasing their exposure to shorter-term, relatively safer credits. By raising interest rates dramatically, the Fed has made that alternative more attractive than it has been in years. For example, for those concerned about inflation, the yield on 5-year TIPS has increased from about -1.6% at the start of 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 low to no correlation with the economic cycle risk of stocks and/or the inflation risk of traditional bonds but have also provided risk premiums. The following are alternative assets that may provide diversification benefits. Alternative funds carry their own risks; therefore, investors should consult with their financial advisors about their own 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 increasing deductibles and tougher underwriting standards) have become more favorable. Those changes led to returns being well above historical averages in 2023. Investors can consider such funds as SRRIX, SHRIX and XILSX.
Private middle market lending (specifically senior, secured, sponsored, corporate debt): Base lending rates have risen sharply, credit spreads have widened, lender terms have been enhanced (upfront fees have gone up), and credit standards have tightened (stronger covenants). Investors can consider such funds as CCLFX and CELFX.
Consumer credit: While credit risks have increased, lending rates have risen sharply, credit spreads have widened, and credit standards have tightened. Investors can consider such funds as LENDX.
Long-short factor funds. Investors can consider such funds as QRPRX and QSPRX.
Commodities. Investors can consider such funds as DCMSX.
Trend following (time-series momentum): 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 Successful Investing
