Will Trump’s Fiscal Stimulus Create Inflation?

Financial markets have reacted strongly to the election of President Donald Trump. While equities in the US and elsewhere have risen strongly, in turn a result of higher inflation expectations. 

Mar 29, 2017 | John Greenwood

Financial markets have reacted strongly to the election of President Donald Trump. While equities in the US and elsewhere have risen strongly, reflecting expectations of stronger growth and therefore improved corporate earnings, bond prices have fallen and yields have risen, in turn a result of higher inflation expectations. 

Fiscal deficits do not necessarily lead to inflation

Among the main drivers of higher inflation expectations, one is the idea that a larger fiscal deficit will inevitably lead to higher inflation. The Trump program promises higher defence expenditures, increased infrastructure spending, and tax cuts. The perception in the financial markets is that this adds up to higher deficits and higher inflation.

The last time such a major fiscal spending program with substantial increases in defence spending and enlarged deficits occurred was under President Ronald Reagan. However, although the budget deficit surged from 1.3% of GDP in 1980 to 5.9% by 1986, inflation actually fell steeply during this period. The reason was that monetary policy was very tight, to counter the double-digit inflation of the late 1970s and early 1980s. In other words, fiscal policy is not inflationary unless it is also accompanied by a surge in monetary growth. So unless US monetary growth surges from its current very modest growth rate, the risk of inflation is being grossly over-exaggerated.

The Phillips curve relationship is not a reliable predictor

A second theory of inflation that is popular among academics, central bankers and financial market participants is that there is a strong relation between the level of available capacity in the economy -- represented by the output gap, the level of capacity utilization or the unemployment rate -- and the rate of inflation. These variants of inflation theory are collectively known as “Phillips Curve” explanations of inflation.

The statistical problem is that these relationships have a very varied track record. It is more an empirical observation than a theory of inflation. In reality its components – labour market tightness and inflation or wage increases – are both affected by money and credit growth, although other factors may also play a role. Typically as the business cycle expands, employment rises (or unemployment falls) and in the late stages of such an expansion inflation may rise. But it is monetary expansion that is the underlying driver of the increased expenditures that in turn tighten the labour market and push up inflation. However, idiosyncratic factors may occasionally affect unemployment and inflation, causing the Phillips curve relationship to go awry.

So why are widening fiscal deficits and the Phillips Curve not reliable predictors of inflation? The reason is that inflation and deflation are fundamentally monetary phenomena. While rising fiscal deficits or falling unemployment may accompany faster money growth, on their own they are neither a necessary nor a sufficient condition for a sustained increase in inflation.

When will inflation rate rise?

So is monetary growth really a superior predictor of inflation in the broadest sense? Of course there is also controversy among economists about the relationship between money and inflation, but when properly understood and applied it is a far more dependable relationship than either the (Keynesian) fiscal deficit or Phillips curve theories of inflation.

Currently the rates of growth of money and credit – and wider measures such as shadow banking credit – remain subdued, not enough to permit a sustained rise in the US inflation rate.

In turn this implies that the current business cycle expansion has several more years to run before the Fed needs to start “tightening” rather than “normalizing” rates.