Spending without ending

Rising government deficits and debt may eventually lead to inflation.

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Key takeaways

  • US government debt already represents an unprecedented 100% share of gross domestic product.
  • Continuing to increase the debt is unsustainable in the long term.
  • History shows that high government debt often leads to more inflationary policies.
  • Concerned about inflation? Consider diversifying your portfolio with non-US and low-priced value stocks as well as inflation-resistant assets like Treasury Inflation-Protected Securities (TIPS) and commodities that have historically benefited from rising inflation.

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During the past 2 decades, the federal government's debt has grown faster than at any time since the end of World War II, running well ahead of economic growth. The debt now equals more than 100% of gross domestic product (GDP), a level of debt far greater than the average over the past 50 years. Since the start of this year, massive new spending on programs to mitigate the effects of COVID-19-related economic shutdowns have further raised the debt and many election year policy proposals from both parties call for further increasing government spending.

Does debt matter?

Decades ago, members of both political parties expressed concern about the impacts of government debt and spending. Many Democrats as well as Republicans supported a constitutional amendment requiring a balanced budget and from 1998 to 2001, congressional Republicans and a Democrat president produced balanced federal budgets.

Today, though, bipartisan support exists for unbalanced budgets that result from lower taxes and higher spending. In 2019, the Trump administration and Democrats in Congress agreed to lift the "debt ceiling" which would have forced a government shutdown and in 2020, both parties supported new spending to soften the impact of COVID-19. Unlike in previous presidential election cycles, when candidates as dissimilar as California governor Jerry Brown and businessman Ross Perot campaigned for balanced budgets, this year's candidates are not focused on the issue.

But while deficit spending has bipartisan support even in today's highly polarized political environment, Dirk Hofschire, senior vice president of asset allocation research, warns that today's spending in the US and other large economies is likely to have long-term consequences. "Debt in the world's largest economies is fast becoming the most substantial risk in investing today," he says. New Fidelity research suggests that higher debt is not a recipe for faster economic growth, and that the responses by policymakers to that debt can ultimately lead to higher inflation and more volatile financial markets than in the past.

Hofschire points out that in addition to the need for pandemic-driven economic relief, high government debt is also the result of a number of factors such as the increased demands of an aging population for programs such as Social Security and Medicare.

"Fidelity's Asset Allocation Research Team believes the rise in debt is ultimately unsustainable," he says. "Historically, no country has perpetually increased its debt/GDP ratio. The highest levels of debt ever all topped out around 250% of GDP. Since 1900, 18 countries have hit a debt/GDP level of 100%, generally due to the need to pay for fighting world wars or extreme economic downturns such as the Great Depression. After hitting the 100% threshold, 10 countries reduced their debt, 7 increased it, and one kept its level of debt roughly the same."

Hofschire looks to these historical examples to consider what may happen in the US as government debt passes 100% of GDP. He expects political pressures for monetary and fiscal policymakers to take a more active role in the economy will lead to the return of inflation in the future. As he puts it, "Government policies are likely to drift toward more inflationary options."

More spending on the way

In addition to the increased debt due to the needs of an aging population, other political pressures are fueling demand for new spending. A growing number of politicians and their supporters believe existing policies concentrate income and wealth in the hands of big businesses and wealthier individuals. They want to use fiscal policy to counter this and stimulate the economy by putting money directly in the hands of low- and middle-income consumers who are more likely to spend rather than save.

Inflation, but when?

If these free-spending fiscal policies are adopted while interest rates stay low and credit remains abundant, the likelihood of inflation could increase. The question is how long it might take for inflation to tick up, and history suggests that the timing is uncertain.

To be sure, many predicted a surge in inflation the last time the federal government made a major change in economic policy by cutting interest rates and buying financial assets in the wake of the global financial crisis, but inflation mostly failed to appear.

However, Hofschire believes the revival of those monetary policies combined with increased fiscal stimulus makes the eventual return of inflation likely despite the prospects for some short-term disinflation as the economy struggles to recover from the ongoing COVID-19 pandemic.

"Inflation is unlikely during a recession or when there is still large spare capacity in the economy. However, in conjunction with greater fiscal experimentation during a period of economic expansion, the combination is likely to become more inflationary against a backdrop of higher growth expectations. New secular trends such as de-globalization may also contribute to a more inflationary backdrop than in the recent past."

If the Fed directly finances these policies—either by lending directly to fund consumer spending or by printing money and giving it to the government—these policies are likely to be even more inflationary.

What to consider

A long-term asset allocation plan that includes a mix of stocks, bonds, and cash that aligns with your goals, time horizon, and your ability to manage risk can help you achieve your financial goals even in an environment of higher inflation.

Investors concerned about the prospect of higher inflation in the future may want to consider further diversifying their portfolios by adding exposure to asset classes that have historically benefited from higher inflation. These could include Treasury Inflation-Protected Securities (TIPS) and commodities. Non-US and low-priced value stocks might also benefit in a more inflationary environment, after trailing US and growth stocks amid the disinflation of the past decade. In a world of higher inflation and continued low interest rates, bonds still play a big role in helping to preserve capital but their historical tendency to gain when stock prices are falling may diminish.

If you want to create a plan with inflation in mind or want to refine your existing plan, try our online tools in the Planning & Guidance Center. Or for professional help, consider a Fidelity advisor.

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