Inflation and the Accuracy of Public Debt Forecasts

An important measure of U.S. fiscal health is the nominal dollar value of public debt owed by the federal government. But a more useful measure is the ratio of the public debt to gross domestic product (GDP), which is simply the federal debt held by the public divided by the U.S. economy. This ratio gives a better sense of the country’s relative debt burden.

While an important measure to track, the ratio is also difficult to accurately forecast. In this blog post, we examine the association between inflation and forecast errors of the public debt-to-GDP ratio. We found that forecasters tend to overestimate the future debt-to-GDP ratio during periods of high inflation and underestimate it during periods of low inflation.

How Inflation Can Affect the Debt-to-GDP Ratio

The U. S. government typically spends more than it collects in revenue. This shortfall, called the fiscal deficit, is covered by borrowing from the public in the form of Treasury securities. Most of these securities are nominal, as they involve the promise of future repayments in fixed dollar terms. As the price level rises over time, the dollar value of outstanding debt remains unchanged, and so its real value falls. Note that the U.S. government does issue some forms of debt that guarantee real, not nominal, returns (like Treasury Inflation-Protected Securities, or TIPS) but generally speaking, inflation causes the real value of the public debt in the U.S. to fall.

But inflation isn’t the only thing that affects the public debt-to-GDP ratio. This ratio is simultaneously affected by two other factors: the amount of debt the U.S. government issues and the amount of goods and services the U.S. produces. Reductions in the nominal stock of debt, higher domestic production (i.e., real economic growth) and inflation all contribute to reducing the public debt-to-GDP ratio.

Public Debt Forecasts by the CBO

U.S. fiscal policy, which involves the setting of government spending and taxation, is a joint responsibility of the legislative and executive branches of government (i.e., Congress and the president, respectively). To set and evaluate fiscal policy, these branches of government rely on forecasts produced by the Congressional Budget Office (CBO). The CBO produces forecasts for the estimated path of public debt, given current policies and macroeconomic conditions. These forecasts are published every year, typically over 10-year horizons.

The first figure plots the observed values of the public debt-to-GDP ratio at the end of each fiscal year from 1990 to 2024 in black, along with the CBO’s forecasts of the debt-to-GDP ratio in light blue. If the CBO’s forecasts were perfect, the light blue lines would overlay perfectly onto the black line.During the period we study, the CBO generated each of its annual forecasts within the first six months of the calendar year. Additionally, between 1991 and 1995, the CBO’s forecast horizon was five years; after 1995, it became 10 years. We truncated the last forecasted fiscal year at 2024. Lastly, from 1991 to 1999, we show the CBO’s forecasts of the ratio of public debt to potential GDP rather than public debt to GDP because the CBO forecasted only potential GDP until 2000. Potential GDP tends to track GDP closely but can deviate in the event of large business cycle fluctuations.

Public Debt-to-GDP Over Time: Realized vs. Forecasts

SOURCES: Congressional Budget Office, U.S. Office of Management and Budget, and authors’ calculations.

Forecast Errors

Predicting the future path of macroeconomic variables is hard, as the economy is constantly subject to structural and policy shocks. We want to understand, however, whether there are systematic deviations of the forecasts from the realized variable. To this end, we compute forecast errors: For each of the forecasts in our data, we subtract the forecasted public debt-to-GDP ratio from its realized value. Note that this means we have multiple forecast errors for each year; taking the year 2010 as an example, we can see in the first figure that there were several forecasts of the public debt-to-GDP ratio in that year, generated between 2000 and 2010.

Debt-to-GDP Forecast Errors and Inflation

To explore the relationship between forecast errors and inflation, we begin by plotting the two series in a single figure with two y-axes. The second figure plots annualized consumer price index inflation (right y-axis) during the fiscal year against the forecast errors that are obtained by subtracting the CBO forecast from the realized debt-to-GDP series at each point in time. A visible pattern emerges: Forecast errors tend to be negative in the early and later parts of the sample (meaning that the forecasts overestimated the path of the debt-to-GDP ratio), when inflation was above its 2% target, and mostly positive in the middle part of the sample (meaning the CBO underestimated the path), when inflation was at or below target. In other words, the CBO tends to overestimate the path of public debt when inflation is high and tends to underestimate it when inflation is low.

Annual Inflation and Public Debt-to-GDP Forecast Errors

SOURCES: Congressional Budget Office, U.S. Office of Management and Budget, U.S. Bureau of Labor Statistics, and authors’ calculations.

To formalize this relationship, we calculated the average of the original public debt-to-GDP ratio forecast errors for each fiscal year. The third figure shows the relationship between these average errors and average inflation over the respective period, where each point in the scatterplot represents a fiscal year between 1991 and 2024. Recall that because our formula for the errors is “observed ratio minus forecasted ratio,” positive average errors correspond to underestimates (i.e., the CBO forecasted a lower debt-to-GDP ratio than was realized).

Why do we see an association between higher inflation and overestimates of the public debt-to-GDP ratio? While we have not established a causal link between inflation and public debt-to-GDP forecast errors, it helps to remember that inflation forecasts themselves are often inaccurate, especially at longer horizons. Since the debt-to-GDP ratio is sensitive to inflation, this generates inaccuracies in the forecasts for these series. Many other factors could contribute to this relationship, namely the business cycle itself: Periods of low inflation could be periods of slower economic activity, which require more help from the government in the form of discretionary fiscal policy, thus resulting in faster growth of public debt.

Improving Forecasts Can Better Inform Fiscal Decisions

The public debt-to-GDP ratio is a measure of a country’s ability to pay off its debts and is affected by inflation. Predicting the public debt-to-GDP ratio in the U.S. helps Congress and the president establish fiscal policy. However, in recent years, those predictions have suffered from some amount of error, the nature of which is associated with the level of inflation in that year, which itself is hard to forecast. Thus, better understanding of the exact relationship between inflation and the CBO’s forecasts of the public debt-to-GDP ratio may improve the forecasts of that ratio, thereby better informing U.S. fiscal policy decisions.

Note

1. During the period we study, the CBO generated each of its annual forecasts within the first six months of the calendar year. Additionally, between 1991 and 1995, the CBO’s forecast horizon was five years; after 1995, it became 10 years. We truncated the last forecasted fiscal year at 2024. Lastly, from 1991 to 1999, we show the CBO’s forecasts of the ratio of public debt to potential GDP rather than public debt to GDP because the CBO forecasted only potential GDP until 2000. Potential GDP tends to track GDP closely but can deviate in the event of large business cycle fluctuations.