Coordinated central bank “inflation shock” posed by S&P scenario

In its recent Global Graying reports on the negative effects of aging on the fiscal soundness of governments, Standard & Poor’s highlights why investors need to be concerned about inflation.

My posts from June 28, US credit rating could drop within 10 years, and June 29, Credit rating agency says US fiscal readiness deteriorating covered other aspects of S&P’s Global Graying reports.

Since then we have received permission from S&P to post its main report, Global Graying: Aging Societies And Sovereign Ratings, and its US report, Global Graying Country Report: United States of America, online here so that you can read the results yourself. The reports aren’t publicly available on S&P’s web site.

The main report looks at the impact of aging on public credit ratings for thirty-two industrialized countries: all European Union members plus the U.S., Canada, Australia, New Zealand, Japan, Korea and Norway.

The following chart shows S&P’s projected median debt of these countries in percent of Gross Domestic Product, between now and 2050, under several different scenarios (the original is on page 7 of the main Global Graying report).

The gray bars show the baseline scenario. In this scenario, each government “does absolutely nothing except for borrowing for any budget shortfall that may materialize. This will lead to a gradual increase of total government expenditure as age-related outlays creep upward, followed by the additional interest costs of the rising national debt.”

The worst-case scenario, shown by the yellow line, is the discriminating investor scenario. “This scenario assumes that investors begin to demand compensation for lending to riskier borrowers. In our example, investors charge one basis point extra over the 3% real rate for every percentage point that the net debt ratio exceeds 60% of GDP. This is broadly in line with the spreads currently observed among Eurozone sovereigns.”

The blue line shows a related lower interest rate scenario. “Instead of assuming the base-case 3% real rates, this scenario is rerun with a lower rate of 2%, more akin to what has been observed in the recent years of ample global liquidity.”

The “real rates” referred to in these two scenarios are the equivalent of the base interest rate on TIPS and Series I Savings Bonds. S&P is saying that historically, real rates have run in the 3% range; one scenario pegs real rates at a higher level under the assumption that investors would require compensation for the additional risk of loans to governments without pristine credit ratings; the other scenario pegs real rates at a lower level under the assumption that investors wouldn’t be able to get a better deal elsewhere.

The best-case scenario, shown by the line marked by green squares, is the no aging scenario. “This assumes that all governments enact radical legislation that would have the effect that no additional age-related spending pressures would build up beyond current levels.” What this would mean in the US is limiting Social Security and Medicare expenses to current levels as a per cent of Gross Domestic Product. As more and more people pass retirement age, they would each get a smaller slice of the Social Security-Medicare pie. AARP!

The scenario shown by the line marked with red triangles is the balanced budget in 2008 scenario. “This assumes that adjustment measures are taken that would lead to a balanced budget in 2008. Once this is achieved, the government reverts to the “fiscal autopilot” and does nothing, except for borrowing to pay for the incremental age-related (and interest) expenditures as they occur.” Note that this scenario, unlikely as it is, doesn’t really help much.

In fact, other than the no-aging scenario, the best scenario in terms of government debt and the fiscal soundness of governments is the inflation shock scenario, shown by the dark red line with x-shaped markers. This scenario “assumes that the central banks will in a surprise move allow inflation to rise to 20% in 2025 and thereafter. The reasons for this do not really matter, but it may well be that the ‘inflation tax’ is levied with the desire to erode the real value of government debt.”

Interesting, isn’t it, that of all the scenarios S&P has dreamed up, the inflation shock scenario is the most effective except for the politically impossible “no aging” scenario? Moreover, implementation of this scenario is in the hands of central bankers, rather than politicians, which increases the possibility of something actually happening.

S&P makes it clear that it’s not making predictions in these reports. Instead, it’s giving warnings. S&P says that it fully expects governments to get their acts together before their credit ratings descend to junk bond status.

Nonetheless, there’s a flashing red light here for investors. Over the next 45 years you can expect the world’s governments to be huge borrowers and borrowers love inflation.