The inflation dynamics in the United States could face renewed challenges, particularly under the fiscal policies expected from President Trump’s administration. Fiscal theory posits that significant federal deficits, particularly those without an explicit plan for future paydowns, are a critical driver of inflation. According to economists advocating this viewpoint, large debts can lead to skepticism among investors about the government’s fiscal discipline, which in turn diminishes the perceived value of the dollar and spurs inflationary pressures, even in the absence of an expanding money supply as suggested by traditional monetarist theories.
A prominent advocate of fiscal theory, economist John H. Cochrane, argues that merely looking at the total federal deficit fails to capture the full picture. He emphasizes that the market’s perception of excess government spending plays a crucial role. Historically, the U.S. Treasury maintained a pattern of responsible borrowing—incurring debt during emergencies, then paying it down relative to its GDP. The pandemic-induced stimulus, however, saw substantial unfunded spending, leading to a belief that such debts would not be repaid, intensifying inflation expectations and negatively impacting the market value of government debt.
The foundational principle of fiscal theory is that the market value of government debt reflects expectations about the future. When there is a perceived lack of fiscal discipline, the anticipated future surpluses decrease, which contributes to rising inflation. For instance, during the COVID-19 crisis, the rapid increase in governmental debt coincided with a loss of credibility in fiscal policy. Cochrane highlights that restoring this credibility will be challenging, taking time and consistent fiscal responsibility, as reputations once lost may not be easily regained.
Cochrane also discusses the role of the Federal Reserve in the inflation narrative, arguing that while the Fed influences inflation through monetary policy, its power may be overstated. He critically examines actions like quantitative easing, contending that simply swapping cash for bonds does not meaningfully alter the economic fundamentals when these instruments essentially fulfill the same role as claims on future tax obligations. Hence, regardless of the money supply increases, if investors lose confidence in the government’s fiscal management, inflation may still rise independently of these measures.
Given the potential risks tied to traditional bonds in this landscape, Cochrane advocates for Treasury Inflation-Protected Securities (TIPS). These securities are structured to provide an interest rate that adjusts with inflation, thereby offering superior value to standard bonds, especially for those approaching retirement. With yields ranging from 1.8% to 2.2%, while lower than historical averages, they are considerably better compared to negligible rates seen in recent years, making TIPS a prudent choice for preserving purchasing power.
Advice for individuals in or near retirement includes diversifying investments in TIPS with various maturities to manage risk and ensure income. Cochrane suggests holding diversified positions and potentially using a medium-term TIPS fund for flexibility as bonds mature. Though he acknowledges the unpredictability of bond market prices, he stresses that securing TIPS is a wise strategy to mitigate inflation’s effects and maintain financial stability until a reliable fiscal policy environment returns. Historically, moments of fiscal responsibility have emerged to counterbalance periods of debt; hence, a hopeful outlook remains on the potential for future bipartisan reforms that could stabilize government finances.