Rising government debt levels and questions about inflation may be on the mind of investors as the economic pressures of COVID-19 have led to record levels of funding and fiscal stimulus from central governments.

These measures have supported the economy and work to ensure that the financial system can continue to function. Understanding how government debt and inflation are related as well as their economic implications is useful knowledge for all investors.

How do governments raise money?

When the average consumer is looking to purchase a home or vehicle, often they turn to a commercial bank for lending in the form of a mortgage, line of credit or loan. When the Government of Canada is looking for lending, they turn to the Bank of Canada, which issues debt on their behalf.

To do this, the Bank of Canada will hold an auction of bonds to raise funding from different players in financial markets such as brokers, private banks and dealers. Later, investors will purchase these bonds from these players to hold in their investment account. A Government of Canada bond will pay interest to the investor (as compensation for lending them money) and at maturity, the principal is returned to the investor. At this time they can choose to buy another bond or invest otherwise.

Aside from borrowing, the Canadian government can also use other tools such as adjusting corporate and personal income tax rates to obtain funding. Compared to increased borrowing, increasing tax rates is a much greater bureaucratic process and is also typically a far less popular option among the general public.

Government debt is not new

Historically, national debt levels in the United States and Canada climbed each century as a consequence of wartime funding (Civil war, WWI & WWII) and the introduction of social programs.

In the chart below, you can see that government debt as a percent of Gross Domestic Product (GDP) has been historically higher in the 20th century. Using government debt as a percent of GDP as a representation of overall government debt measures how a given country can pay off its debt through production of its final goods and services. Generally speaking, a higher debt to GDP ratio indicates that a given country will be less likely to pay back its debt and has a higher risk of default.

The chart also shows the debt-to-GDP ratio exceeded 100% around 1945 when WWII ended, which reflects a debt level greater than the value of goods and services that the U.S. and Canadian economies produced. Following WWII and the ensuing recession, the ratio began to drop as economic conditions normalized. Regarding high levels of debt, history has shown we have been here before, albeit this time the rising figure has been catalyzed by a unique historic pandemic event.

Interest rates on government debt

Looking at the total amount of debt as a percent of GDP provides insight into the relative financial situation of the government, but it does not provide the full story. Another thing to consider when looking at government debt is how much it costs to service that debt.

Similar to when a client is shopping for a mortgage, the government also has to be mindful of prevailing interest rates that will affect the total cost of borrowing. Looking at the total value of a mortgage is important, but the more meaningful number to assess the affordability of the mortgage or debt is the monthly payment which is impacted by the mortgage interest rate.

Though debt levels have increased over the past few decades—with a recent large increase due to COVID-19 stimulus spending—interest rates have also come down substantially and are currently sitting near zero. This means that the cost of servicing these large national debts remains manageable despite the size of the debt increasing.

In the below chart, we can see that U.S. national debt interest payments (as a percent of total government spending) rose following WWII and the dot-com bubble of the late 1990’s, where they were in fact higher than 2019. Though we do not yet have data for 2020, we can safely expect that debt expenses will have risen with the recent increase in the amount of total debt.

However, this new debt would have been issued at historically low interest rates, which does not increase the associated borrowing expenses as much as one may initially think. The cost to service the current debt would be expected to remain well below the historic highs of the 80s and 90s where interest payments as a percent of total federal outlays exceeded 15%.

What happens if interest rates rise?

When interest rates increase, and therefore the cost of servicing debt increases, it usually means two things; the economy is doing well with employment at full capacity and inflation is beginning to run higher. Under such circumstances, the central banks may look to increase interest rates in order to gently cool off the economy. As of the time of this article, neither of these conditions are present as unemployment precipitated by the pandemic remains at record highs and inflation remains well below central bank targets.

How are inflation and government debt related?

Inflation is an important concept as it measures the rate at which the average cost of a commonly purchased basket of goods and services increases over time. The increase in the price of this basket broadly represents the increase in prices of goods and services across a country and can impact consumers negatively if prices are increasing but wages are not. For example, say your monthly income remains the same but you find yourself paying more each month for essentials such as toilet paper and food. In this situation, inflation would lead to consumers having less purchasing power, which is undesirable.

Inflation does not only impact consumers, but it can also decrease the purchasing power of a currency, such as a country’s locally denominated debt. This concept relates to our post-WWII era (1946 to 1955) example where the average inflation rate was 4.2%, double the typical central bank inflation target of 2%. Subsequently, inflation reduced the 1946 federal debt/GDP ratio by almost 40% within a decade as the country’s locally denominated debt lost value (source: Bloomberg).

In summary, when a government borrows in its own currency (eg. U.S. government borrowing in USD), higher inflation will tend to devalue the local currency and as a result, the amount owed. In this case, inflation reduces the national debt load, which could be seen as a positive, but would negatively impact the bondholders who are effectively the lenders of the government debt.

An increase in debt leads to a greater supply of money in the economy which can sometimes be a precursor to rising inflation. With that being said, inflation will likely remain low until the excess slack in the labour market is gone and the economy has fully recovered.

The U.S Federal Reserve has already shifted to more accommodative policies to allow inflation to gradually increase in the short-term, raising rates only as a reactive, not proactive measure. This is expected to allow for longer periods of low rates, which would translate into an extended period of lower borrowing costs for consumers, businesses and the government. Low borrowing costs tend to encourage spending, which then tends to bolster economic growth and financial market stability. Inflation is often stigmatized but is not always a bad thing for consumers. In many historical cases, wages typically keep pace, equity values rise on an overall strong economy and mortgage debt is lowered in real terms.

Takeaway for investors

Eventually, the pandemic will be behind us and things will begin to normalize. The economy will continue to grow and unemployment will fall. This will increase GDP growth, lower government spending on social services and increase tax revenues—all of which translates into more money for the government to service their debts.

Once the economy has fully recovered, we may begin to see inflation pick back up. It is hard to say what the level of inflation will be at that time, but the central banks will be watching and will strive to maintain their mandates to ensure that inflation does not get out of control.

In an environment of rising inflation and sustained near-zero interest rates, certain asset classes may be expected to be better positioned to perform. Recognizing government debt can still play an important part in any diversified portfolio, an investor will also want to ensure that their portfolio has certain assets which will outpace inflation too.

Government debt will continue to serve its role in many diversified portfolios as a low risk solution, but as we discussed, the low interest rate environment is also lowering the compensation received when investing in government debt, especially after the effects of investment management fees and inflation. While government bonds may provide security for a more risk averse investor, equities and corporate bonds can be looked to for better inflation-adjusted growth.

With this, it’s important to remember that all investors are unique and have their own tailored risk tolerance. Selecting the right asset mix consisting of equities, corporate and government bonds can be a daunting task. Understanding the characteristics of how these securities may behave under changing market conditions, such as rising government debt, will better position an investor to meet their long-term financial goals.