Weekly Update - Excess savings eaten up by inflation

During the Covid years, governments funding needs vastly on the back of their massive support programmes. This was in part covered by central banks’ purchase programmes. More recently, governments have been able to keep fiscal policy accommodative without wrecking their budgets thanks in large part to high inflation. Both factors are set to fade in 2024 as central banks run down their balance sheets and inflation falls, leaving governments to wrestle big deficits (and even with fiscal slippage in France and Italy) in what is an election year on both sides of the Atlantic. This leaves them with no option but to cut deficits, by slashing spending and/or raising taxes.

Public deficits remain high. Public sector deficits in the world's leading economies swelled in the Covid crisis, peaking in 2020 at 14% in the United States, 7% in the euro area and 13% in the United Kingdom. These huge financial shortfalls were only made possible by the support of central banks, which bought up stacks of government bonds: the Fed spending $3,800bn, the ECB €2,000bn and the Bank of England £430bn. But when inflation took off in late 2021 central banks stopped buying and started to run down their holdings, either by not reinvesting cash from maturing bonds, like the Fed and ECB, or by actively selling off bonds, like the BoE. Even so, by 2023 deficits remained elevated (6%, 3.5% and 4.5% of GDP, respectively). More worryingly, the 2023 budget slippages announced in France and Italy – 5.5% and 7.2% vs. 4.9% and 5.3% projected – could revive fears about the sustainability of public finances in the main developed economies.

Debt ratio falling thanks to inflation. Deficits may be high but public debt ratios have declined since 2021, mainly thanks to inflation. Inflation is bad for the economy in many ways, most notably by undermining purchasing power, but it does help the public treasury in two ways. First, in many countries, VAT and income tax receipts rise faster than spending, even when public sector salaries and benefits are indexed to inflation. Second, higher inflation means that – all else being equal – nominal GDP will grow faster, automatically reducing deficit and debt ratios to GDP. But these benefits only apply as long as interest rates - and hence debt service costs - remain under control.

No more free lunch for governments. Things have changed, however. For one thing, governments can no longer look to central banks for funding. For another, inflation has fallen, and interest rates have risen. This means governments must now rein in their deficits if they are to cut debt and keep service costs affordable. We estimate that the public sector deficit requires to stabilise their debt/GDP ratios is 3.9%%, 4.4% and 4.1%, respectively in the United States, euro area and United Kingdom. For now, bond markets are paying little attention to this issue – spreads between euro area sovereigns have narrowed slightly since the turn of the year – but a fresh bout of debt market tensions could force governments to tighten fiscal policy. How to achieve this is already a hot topic in France but this debate may not only intensify further but spread to other countries, including the US and UK once the elections are over.

In the highlights of the week, we chose to talk about inflation data and credit data in France as well as inflation and spending data in the United States: 

• The disinflationary trend continues in France. Inflation fell from 3% in February to 2.3% in March, reflecting a sharp moderation in food inflation, stagnant prices for manufactured goods and continued disinflation in services. As for bank lending, the February data also show a further slowdown. Outstanding loans to households and businesses rose by just 0.7% year-on-year (compared with 5.4% in February 2023), illustrating the weakness of mortgages and short/medium-term business loans against a backdrop of high interest rates and tighter lending conditions. These two figures are in line with our scenario of the start of an ECB rate cut in June.

• The US consumer deflator - the measure of inflation most closely followed by the Federal Reserve - was published in line with expectations for the month of February in underlying terms, rising by 0.3% after 0.5% in January. At the same time, personal spending grew faster than expected, increasing by 0.8% over the month, compared with the 0.5% anticipated by the consensus. Given that household consumption is the main driver of the US economy's performance, this data confirms the Fed's room for manoeuvre with regard to the start of its rate-cutting cycle.

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