Will Government Spending Unleash Inflation?

There is an underlying belief, once coronavirus is contained, that North American economies can expect a burst of inflation as the exploding public deficits come home to roost. In both the US and Canada, federal government deficits are headed for perhaps as much as 20% of GDP. A combination of outright direct payments and government loans have been approved to ease the burden of a continent-wide shutdown. Both the Federal Reserve Bank and the Bank of Canada are assisting by undertaking bond buying programs to include public and private debt.  When completed, it is anticipated that both central banks will have doubled their initial balance sheets.  The central banks have made it clear they intend to pump unprecedent amounts of cash into the banking system. The sheer size and breadth of central bank purchases has generated concern that eventually there will be a big price to pay in terms of higher inflation.How valid is this concern?

 Prior to the outbreak of the virus, commercial banks were well-capitalized and, on balance, held reserves in excess of regulatory requirements. Canadian banks have generally been more conservative than American banks. American banks still bear some of the scars from the 2008 crisis such that they, too, held excess reserves. Even more importantly, the banks must manage their portfolio with regard to the risk and potential default of loans. The injection of greater amounts of liquidity does not necessarily mean that the commercial banks will be a source of virtually unlimited credit expansion. The commercial banks have to be satisfied that the potential borrowers from the banks must have a need for loans and the ability to take on that loan and repay principal and interest.  As the express goes “you can lead a horse to water, but you can’t make it drink”. Despite the Fed’s efforts with four rounds of quantitative easing, U.S. commercial banks have maintained excess reserves over the past decade. The uncertainty dogging today’s financial world would not likely change banks’ behaviour. Bank lenders will still need to feel comfortable with their borrowers. And, the weaker those borrowers appear, the less likely the banks will open the spigot.

More to the point, the expansion of the monetary base is used primarily to stabilize the financial markets. The aftermath of a historic decline in equity values and the accompanied temporary instability in the debt markets forced the central banks to intervene with bond purchases. The financial markets were just too wobbly and this was a dangerous sign. The financial institutions knew they had a huge problem in preparing for loan losses of a scale even greater than those experienced in 2008. On top of that, corporate balances were totally debt- laden and this just exasperated the stress in the fixed income markets. The central bank money injections in the commercial banks is not going towards the purchase of goods and services. The money is provided by the federal governments not as a “stimulus” (a mistaken belief) but to replace the lost incomes by individuals and businesses. Further evidence to this point, the financial institutions remain weakened for two basic reasons. The yield curve is very flat which impacts profits and loan losses are mounting as the shut down remains in force. These conditions are more prevalent in a deflationary world which lies ahead.