Deficit spending in the United States is surging. Last year, the federal government outspent earnings by a greater degree than any time since World War II, and this year, the Biden administration’s stimulus package is set to widen that gap. This has investors ratcheting up their inflation expectations. The difference in yields, or breakeven, between ordinary 10-year Treasury notes and the inflation-adjusted equivalent—a common indicator of where the market thinks inflation is headed—has been rising since last spring.
Yet the breakeven for 10-year T-notes is lower than for five-year T-notes, suggesting investors are skeptical that pandemic-induced spending splurges will push up inflation far into the future. And research finds that most Americans take a similarly nuanced view of short-term fiscal policy versus its long-term impact on prices.
Using a randomized control trial, University of Texas’s Olivier Coibion, University of California at Berkeley’s Yuriy Gorodnichenko, and Chicago Booth’s Michael Weber probed the degree to which individuals’ inflation expectations are affected by information about government debt, deficits, and interest rates. Their results suggest Americans change their price forecasts little when told current-year figures, but brace for higher inflation when they sense a long-term trend toward ballooning government debt.
The researchers drew subjects from the US households that report demographic and purchasing information to the Nielsen Company. In December 2018, in a customized survey, they asked people in these households to estimate past and future inflation. They split the 30,000 respondents into seven groups, giving each group a different piece of information about current or future deficits, debt, and inflation rates—then asked again for their short- and long-term inflation estimates.
The groups that were given deficit, debt, or interest-rate figures for 2018 made little to no change to their inflation forecasts on average. Those told that either the federal deficit or US debt were forecast to grow significantly in the coming decade increased their short- and long-term inflation expectations.
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Why Central Banks Need to Change Their MessagePolicy makers want to understand how US households interpret potentially inflationary policies because perceptions alone can feed price rises; if you think your rent is going up, for example, you’ll fight more vigorously for a pay raise at work. Goldman Sachs’s Jeremy Nalewaik, then at the Federal Reserve, finds in a 2016 study that in the 1970s and ’80s, changes in the public’s inflation expectations appeared to predict changes in inflation, though this effect weakened in subsequent decades.
When it comes to creating those inflation perceptions, meanwhile, “our results are not out of line with [US vice president] Dick Cheney’s famous quip that ‘deficits don’t matter,’” write Coibion, Gorodnichenko, and Weber. What might matter more, they warn, is a “persistently worsening fiscal outlook, with rising debt levels in the future.”
Given the partisan nature of the public conversation about deficit spending, the researchers also asked respondents their political affiliation. Independents, after being told that debt was forecast to grow, revised their predictions for government spending, revenues, and inflation, which the researchers interpreted as a belief that politicians would seek to curb this growth through spending cuts and tax hikes, and that central banks might accept higher inflation if it were to reduce the debt’s value. Democrats and Republicans, on the other hand, tended to anticipate little in the way of fiscal- or monetary-policy responses.
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