Blog - Investing Notes
November 14, 2008– Update: Public Debt, Inflation and the Stock Market
When the U.S. government runs substantial deficits, some experts proclaim the dollar's inevitable inflationary debasement and bad times for stocks. Other experts say that deficits are no cause for alarm, because the United States can easily bear more debt. Politicians argue about reducing spending and/or increasing taxes to reduce the deficit. Does a large federal deficit (increase in public debt) spur inflation and, per the concept underlying our Real Earnings Yield Model, thus drive down stock prices? Using roughly annual (end of fiscal year) figures for the level of the U.S. public debt from the Bureau of the Public Debt and contemporaneous Dow Jones Industrial Average (DJIA) and inflation rate data over the period 1929-2008 (80 years), we find that:
The following chart shows on a log scale the growth in the U.S. public debt, both nominal and inflation-adjusted (real), over the entire sample period. Periods of stronger than average debt growth include the Great Depression, World War II and the denouement of the Cold War (the 1980s).
First we look at the relationship between public debt and the inflation rate.
The next chart compares the annual change in nominal public debt, the change in real public debt and the contemporaneous annual inflation rate over the entire sample period. Public debt figures are end-of-fiscal-year, which is the end of June for 1929 through 1976 and the end of September thereafter. Inflation rate data are non-seasonally adjusted 12-month trailing from fiscal year to fiscal year for all years except the 1976-1977 transition year, for which the inflation rate is 15-month trailing (calculated from the consumer price index). Visual inspection reveals no clear relationship between public debt and the inflation rate.
For additional insight, we use this data to construct a scatter plot.
The following scatter plot relates the annual inflation rate to the contemporaneous change in the nominal public debt and the real public debt over the entire sample period. Statistics are as follows:
The Pearson correlation between the inflation rate and contemporaneous change in the nominal public debt is 0.12 and the R-squared statistic is 0.02, indicating little or no relationship between the two series.
The Pearson correlation between the inflation rate and contemporaneous change in the real public debt is -0.24 and the R-squared statistic is 0.06, indicating perhaps a weak tendency for the inflation rate to fall as public debt increases.
Might the change in public debt lead the inflation rate?
The following table shows the Pearson correlations between the inflation rate and the changes in nominal and real public debt for various lead-lag scenarios. Correlations are mostly small and positive (negative) for the relationship between the inflation rate and changes in nominal (real) public debt. These mixed results offer no compelling conclusions about the inflation-debt relationship.
As an additional test, we compute the average next-year inflation rate when the annual changes in nominal public debt and real public debt are above and below their median values for the 80-year sample period. Results are as follows:
When the annual change in nominal public debt is above (below) its median value, the average inflation rate the next year is 4.6% (2.3%).
When the annual change in real public debt is above (below) its median value, the average inflation rate the next year is 2.9% (3.9%).
Again mixed results lead to no compelling conclusions.
Next we investigate connections between U.S. public debt and the U.S. stock market.
The next chart compares the annual change in nominal public debt, the change in real public debt and the contemporaneous change in DJIA over the entire sample period. Public debt figures are again end-of-fiscal-year, which is the end of June for 1929 through 1976 and the end of September thereafter. DJIA returns are 12-month trailing from fiscal year to fiscal year for all years except the 1976-1977 transition year, for which the change in DJIA is 15-month trailing. Visual inspection reveals no clear relationship between public debt and stock returns.
For additional insight, we use this data to construct a scatter plot.
The following scatter plot relates the annual change in DJIA to the contemporaneous change in the nominal public debt and the real public debt over the entire sample period. Statistics are as follows:
The Pearson correlation between DJIA return and contemporaneous change in the nominal public debt is 0.14 and the R-squared statistic is 0.02, indicating little or no relationship between the two series.
The Pearson correlation between DJIA return and contemporaneous change in the real public debt is 0.15 and the R-squared statistic is 0.02, also indicating little or no relationship between the two series.
Might the change in public debt lead stocks?
The following table shows the Pearson correlations between annual DJIA return and the changes in nominal and real public debt for three scenarios: contemporaneous, debt changes lead stocks by one year and debt changes lead stocks by two years. Correlations are mostly small and positive, suggesting weakly that deficit spending tends to stimulate the stock market.
As a final test, we compute the average next-year DJIA return when the annual changes in nominal public debt and real public debt are above and below their median values for the 80-year sample period. Results are as follows:
When the annual change in nominal public debt is above (below) its median value, the average change in DJIA the next year is 11.2% (4.5%).
When the annual change in real public debt is above (below) its median value, the average change in DJIA the next year is 10.5% (5.1%).
These results support a belief that deficit spending tends to stimulate the stock market.
In summary, simple tests suggest that U.S. government deficit spending has a slight tendency to stimulate the U.S. stock market but has no reliable impact on the inflation rate over the next year or two. Annual variability of data makes trading on these conclusions risky.
See Blog Synthesis: The Economy and the Stock Market for other research on relationships between macroeconomic indicators and stock market behavior.
To discuss this research, go to the Economic Indicators Forum.
