Should the US Federal Reserve raise the inflation target from its current level of 2%? And will it? One benefit would be to make hitting the zero lower bound less likely, which would lead to less severe recessions, as Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro (2010), Daniel Leigh (2010), and Laurence Ball (2013) have argued on this website. Other benefits of higher inflation that Kenneth Rogoff has been emphasising for a while might include accelerating the fall in real wages during the recession, and deflating away debt overhang (Rogoff 2014).1
One of the most indebted economic agents is the government. The federal debt limit has had to be raised repeatedly in the past few years, and at the end of the 2013 fiscal year the gross federal debt outstanding was 101% of GDP – the highest ratio since 1948. It is therefore natural to imagine – like Aizenman and Marion (2009) –that inflating away the public debt is possible, perhaps effective, and maybe even desirable. Using a simple rule of thumb to estimate the effect of higher inflation on the real value of debt, they venture that US inflation of 6% for four years could reduce the debt-GDP ratio by roughly 20%.
However, in our recent work we show that the probability that US inflation lowers the real value of the debt by even as little as 4.2% of GDP is less than 1% (Hilscher, Raviv and Reis, 2014). Why is this estimate so small? We show that there are two reasons: first, the private sector holds shorter maturity debt; second, high levels of inflation in the next few years are extremely unlikely.
The peril of rules of thumb
To quantify the reduction in debt value, one might use a simple rule of thumb: multiply the outstanding debt (101% of GDP) by its weighted average maturity (5.4 years at the end of 2012, according to the US Treasury) and by the extra inflation (4%) to get an estimate of a 22% fall in the real value of debt. Yet, each part of this calculation is inaccurate, making it a rather poor approximation.
First, the federal government would only see its burden reduced on the debt that is held by private agents. Any fall in the debt held by Social Security or by the Fed would just lead to lower fiscal surpluses or lower seignorage payments in the future, respectively. Privately held debt at the end of 2012 was just 51% of GDP.
Second, weighted average maturity is a poor measure of the sensitivity of the value of debt to changes in inflation. A more accurate measure is the Fisher-Weil duration of the debt portfolio held by the private sector, and that was 3.7 in 2012.
Third, a permanent increase of 4% is viewed by market participants as close to impossible – after all, if such a large increase was likely, no one would hold the debt at the current high market prices. Given the difficulties that the Fed has had in even keeping inflation as high as 2%, it is indeed hard to imagine 6% inflation suddenly and unexpectedly materialising. Also, the local approximation holds only for small, sudden, and permanent increases in inflation, and cannot be used for gradual and sizeable increases.
All combined, the effect of 0.1% higher inflation forever is only 0.18%. But to get a better estimate, one needs to go beyond rules of thumb.
A forward-looking formula
We show that the way in which the real debt burden of the government depends on inflation can be written in a simple transparent formula (Hilscher, Raviv, and Reis 2014). The formula discounts the nominal payments (coupons and principal payments) that the government owes today weighted by the expected (risk neutral) cumulative inflation year by year.2 Knowing the risk-adjusted probability function for inflation, and the maturity of payments, we can therefore easily calculate the debt burden and then see how higher inflation, through either higher realizations of future inflation or shifts in the distribution for inflation, affect this burden.
Debt maturity and expected inflation in the US
Figure 1 shows the government payments due to the private sector by maturity. Remarkably, they are extremely concentrated on the short end. In fact, three quarters of the payments are due in less than 4.5 years. This has an immediate consequence for the debt burden that the formula above makes clear: only inflation over the next few years can have any meaningful effect on the real value of the debt burden.
Figure 1. US government payments due to the private sector by maturity (Bt), December 2012
Figure 2 shows the risk-adjusted expected average annual inflation for the next 5 years. We estimated these distributions using novel data on inflation options contracts. Notably, inflation expectations are quite anchored, and investors are putting only a very low weight on the probability that inflation is even above 4% in the short run.
Figure 2. Risk-adjusted distributions for average inflation over different maturities, December 2012
Inflating away the debt?
Figure 3 shows the probability that the real value of the debt will fall because of inflation. All the numbers are very small. For example, the risk-adjusted probability of a reduction of the debt burden by more than 4.2% of GDP is less than 1%.
Figure 3. Probability that the fall in the real value of the debt exceeds a threshold
Looking at a series of counterfactuals, we show how different ways to raise inflation affect the estimates of debt debasement: whether the increase in inflation is permanent or transitory, gradual or sudden, raises or lowers uncertainty, is unexpected or partially anticipated. While these differences are important –estimates can easily double or halve across different scenarios – the conclusion remains: even for extreme counterfactuals, plausibly higher inflation has only a small impact on the real value of the debt.
Simply put, in the near term, there is much debt but little extra inflation, and for longer horizons, there can be significant inflation but there is little debt. The total resulting effect is always small.
Looking backwards instead of forward in time, there is a common perception that the US paid its post-war debt via inflation. What is so different now? An important part of the answer is that the maturity of the debt was much longer back then. The Treasury cannot simply start today issuing longer-maturity debt. Investors would realise that, with such a large stock of debt outstanding, higher maturities would raise the temptation to inflate and would demand compensation for the possibility of higher inflation in the form of significantly higher interest rates. The current twin facts that we highlighted – lower maturities and moderate inflation expectations – are mutually consistent.
One way to increase maturity, albeit ex post, is to engage in financial repression, a situation where the private sector is essentially forced to hold long term debt at below-market interest rates. In fact, Reinhart and Sbrancia (2011) suggest that this was the determining factor in inflating away the post-war debt in the US We show that if holders of the debt are forced to receive as payment required reserves that must be held at the central bank for N years, then this is equivalent to an ex post maturity extension. If N is as large as 10 years, then 2.5% more inflation on average over the next 30 years – which previously lowered the real value of debt by 3.7% – now lowers it by 23% of GDP, almost half of the value of privately-held debt. Of course, the side effects of such extreme repression on financial development might well be large.
One way or another, budget constraints will always hold. This is true as much for a household or a firm as it is for the central bank or the government as a whole. If the US government is to pay its debt, then it must either raise fiscal surpluses or hope for higher economic growth; the former is painful and the latter is hard to depend on. It is therefore tempting to yield to the mystique of central banking and believe in a seemingly feasible and reliable alternative: expansionary monetary policy and higher inflation.3 Crunching through the numbers we find that this alternative is not really there.
Aizenman, J and N Marion (2009), “Using Inflation to Erode the US Public Debt”, VoxEU.org, 18 December.
Ball, L (2013), “The case for 4% inflation”, VoxEU.org, 24 May.
Blanchard, O, G Dell’Ariccia, and P Mauro (2010), “Rethinking Macro Policy”, VoxEU.org, 16 February.
Hilscher, J, A Raviv and R Reis (2014), “Inflating Away the Public Debt? An Empirical Assessment”, CEPR Discussion Paper 10078.
Krugman, P (2014), “Inflation Targets Reconsidered”, ECB Sintra conference.
Leigh, D (2010), “A 4% Inflation Target?” VoxEU.org, 9 March.
Reinhart, C M, and M B Sbrancia (2011), “The Liquidation of Government Debt”, NBER Working Paper 16893.
Reis, R (2013), “The Mystique Surrounding the Central Bank’s Balance Sheet, Applied to the European Crisis” American Economic Review, 103(3), 135-40, May.
Rogoff, K (2014), “The 4% Non-Solution,” Project Syndicate, 5 June.
1 Krugman (2014) recently summarises these arguments and adds a few more.
2 If Bt are the nominal payments (coupons and principal payments) that the government owes today and that are due in t years, and if πt is cumulative inflation over those t years, then the present value of the debt burden is:
Σ Rt-1 BtEQ (1/πt).
Rt is the real risk-free interest rate for t years, while crucially EQ is the expectation according to a risk-neutral density.
3 Reis (2013) presents many other instances of this mystique.