Does Government Spending Cause Inflation?

Key takeaways

• Inflation occurs when the cost of goods and services rises over time
• Several factors contribute to inflation generally, and today’s inflation in particular, including consumer demand, supply chain disruptions and energy shortages
• Some economists hold that government spending can cause inflation, while others believe that the current inflationary environment is unusual
• Other economists believe the debate is more nuanced – in other words, it’s about when and where the government spends

Americans remain largely pessimistic about one of the most unusual economies in recent history. Much of this negativity runs back to inflation, with the most recent numbers showing inflation rose 8.5% year-over-year. As the highest spike in 41 years, it’s no wonder rising prices remain top-of-mind for consumers and investors alike.

Depending on who you ask, the cause of this inflation varies.

Some economists blame supply chain deficiencies, while others point the finger at corporate greed. The topsy-turvy housing market and resulting rent spikes probably pushed inflation along, too. And for many, Russia’s invasion of Ukraine and subsequent energy shortages did nobody any favors.

Another common answer is that unprecedented levels of government spending had a hand to play. But historically, economists have largely agreed that the link between government spending and inflation remains weak.

So, what’s the truth? Does government spending cause inflation – or are underlying factors to blame?

What is inflation?

Inflation describes the gradual incline of prices and subsequent decline of a dollar’s purchasing power. In other words, as prices go up due to various economic pressures, one dollar buys less than it used to.

But inflation as we think of it doesn’t just occur in a single good or service. Rather, it’s a broad-based increase, with prices rising at different speeds in different sectors.

Economists measure inflation through metrics like the Consumer Price Index (CPI) and Producer Price Index (PPI). These calculate price changes in a “basket” of goods to measure national inflation levels. The resulting numbers are reported as inflation.

Generally, economists consider a small amount of inflation – about 2% – healthy for growing, functional economies. Moderate inflation encourages consumers to spend now to avoid higher prices later, which keeps money circulating.

But too much inflation – like the levels we’re seeing this year – can damage an economy. Continual price increases push the cost of essential goods and services out of reach for many consumers. Left unchecked, high inflation can even lead to recession.

Types of inflation

Inflation is generally described as the result of demand outstripping supply, or alternatively, the supply of money exceeding demand.

Several factors can play into these equations, from low interest rates, labor market changes or supply shortages. Based on the specific cause of inflation, we can divide it into two categories: demand-pull or cost-push.

Demand-pull inflation

Demand-pull inflation is perhaps the most common kind of inflation. This type occurs when the demand for goods outpaces supply chain growth, pulling up prices.

Demand-pull inflation often pops up when consumer demand rises in growing economies. An expansion in the supply of money or credit (via low interest rates) can also result in demand-pull inflation.

Cost-push inflation

Cost-push inflation occurs when the supply of goods or services fails to meet existing demand, thereby pushing prices up.

Cost-push inflation may crop up when labor or raw materials shortages prevent producers from manufacturing goods quickly. Natural disasters, global pandemics, trade agreements and exchange rate changes can all contribute to cost-push inflation.

Does government spending cause inflation?

Now that we’ve looked at the definition and drivers of inflation, let’s address our question: does government spending cause inflation?

The answer, roughly, is yes – and in other cases, no.

Historical studies on government spending and inflation

Studies of the historical link between government spending and inflation find that the link is tenuous.

In particular, one study by the St. Louis Federal Reserve found that government spending has little to no impact on inflation. In fact, a 10% increase in government spending may lead to a 0.08% decline in inflation.

Others have found that government spending around the world may have minimal impacts on inflation, often in the tenths of a percentage point.

Government spending and Covid-19

On the other hand, modern studies have found that the current link between government spending and inflation may be stronger.

In particular, the 2022 inflation spike followed two major federal spending programs under two administrations. The first, the CARES Act, passed in March 2020, while the American Rescue Plan passed in March 2021.

Collectively, these initiatives aimed to minimize the economic devastation of Covid-19 by distributing three stimulus checks, expanding unemployment benefits and providing extra funds to state and local governments.

While experts have credited these Acts with possibly preventing a recession, economists have also found that their passage correlates with an unusual spike in inflation. By providing extra capital to American households, economists note, consumers were able to go out and spend money they wouldn’t have had otherwise. In turn, this increased consumer demand, pulling up prices.

However, a recent analysis from the San Francisco Federal Reserve found that government spending only contributed to about three percentage points of today’s inflation. These findings corroborate an October 2021 paper that suggested stimulus checks made inflation slightly worse – but not to the extent we’re seeing now.

A full half of today’s inflation, they discovered, stems from ongoing supply chain issues as producers struggle to push out enough goods to meet demand. The war in Ukraine and resulting energy shortage, alongside a turbulent housing market, have also contributed to inflation, pushing up prices from several directions at once.

Not all government spending leads to inflation

However, not all government spending is correlated with higher inflation. It appears that the size and style of intervention matters.

For instance, the recent infrastructure bill is unlikely to contribute to higher inflation. Measures like this aim to buff economic productivity instead of consumer wallets.

In other words, instead of flooding the economy with capital via stimulus checks or tax cuts, they invest in new technologies and jobs. (Both of which, 17 Nobel-winning economists believe, could help ease long-term inflationary pressures.)

So, does government spending cause inflation – or not?

As it stands now, the question is less does government spending cause inflation, and more where and how government spending impacts inflation.

When government activities inject more capital into the economy, consumers have more to spend, which can increase demand. If suppliers fail to meet rising demand, they may hike prices, leading to inflation.

On the other hand, when government activities inject more jobs into the economy, inflation may modulate as capital flows more normally through economic pipelines.

When it comes to our current situation, we can also look beyond our borders for clues.

For example, many European countries provided far less assistance to their economies when Covid-19 hit. However, these countries are also staring down the double-barrel of low supply and inflation ranging from 2.5% to nearly 80%. That suggests that supply chain issues and other outside factors, rather than government stimulus, may have boosted inflation.

How to beat inflation as an investor

Regardless of the specific cause, inflation can spell trouble for investors. Even in higher-earning assets, too-high inflation can lead to poor or negative returns thanks to reduced purchasing power. That’s especially true in savings-based assets like high-yield, money market and certificates of deposit (CD) accounts.

For investors seeking higher returns, these investments may lead to better outcomes.

Stocks

When inflation soars, many investors turn to stocks to provide. While individual prices may rise and fall, and bear markets can temporarily wipe out even the best gains, historically, the stock market has always performed – eventually.

Of course, that doesn’t mean stocks are a guaranteed bet, especially short-term. But with a long-term buy-and-hold strategy, a well-diversified portfolio can beat inflation over years and decades. For a little extra oomph, you can invest in dividend-paying stocks to offset the impact of potential price drops.

Bonds

Bonds tend to offer lower returns than stocks, but long-term, they too can beat inflation. Bonds also comprise a critical component of well-diversified funds, as they lower overall risk and provide more consistent returns than stocks.

When inflation grows inordinately high, investors can also turn to TIPS, or Treasury Inflation-Protected Securities. This special class of Treasury bonds automatically adjust based on changes to CPI, providing inflation-adjusted returns over five, 10 or 30 years.

Real estate

Real estate is another common hedge against inflation. But it’s not just buying rental properties – investing in infrastructure and construction projects can also capitalize on real estate booms.

However, since we may be in a housing recession, real estate may not provide the same protections it has historically. Still, investors who believe real estate may rise again soon may consider “buying low” now to “sell high” later.

Commodities

When inflation picks up, investors often turn to tangible assets like commodities to protect their returns. Commodities include raw materials like copper and oil, as well as agricultural products like grain and beef. With commodities of all kinds experiencing inflation, investing in the right products can produce substantial returns.

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