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Taxes, Budget Deficits and Inflation

A couple of things have come out from different politicians the last couple days which have me shaking my head. File this under big picture macro fundamental anlysis, I suppose. I don’t normally offer up market analysis here, but it’s worth indicating the way one can approach market analysis.

Tax Hikes Leading to Inflation
The first is a statement yesterday by the governor of the Mexican central bank. In talking about forecasts for the year to come he expressed the view that tax hikes instituted in the latest budget could add 50bps (0.50%) to the annual inflation rate in 2010. I can only pressume that he means said tax cuts will somehow filter through into higher consumer prices as a pass on effect.

Now I don’t know the specifics of the tax hikes in question, so I can’t speak directly to the type of pass-along effect there might be and from what directions. I seriously doubt it would ever be a 100% pass through from producers to consumers, and some of the hikes may directly hit comsumers, which wouldn’t be involved in price levels at all. In other words, I have lots of questions about how much pass-along there is likely to be.

On top of that, there are two other elements to the inflation equation. To the extend that pass-along taxes increase prices and/or taxes directly impact consumer it will lower demand. That would tend to put downside pressure on prices. Furthermore, when the government increases taxes it pulls more money out of the system, reducing money supply. If inflation is at least partly a function of money supply, then taxes tend to be a depressive factor rather than an expansionary one.

Government Budget Deficitis of 3%
US Treasury Secretary Geithner was on CNBC this morning talking about the plan to get the US budget deficit down to 3% of GDP with the work on getting it down there starting in 2011. The EU finance ministers set similar targets for several members to reach by 2012-2015. So in other words, the world’s major economies will still be running budget deficits for quite a few more years to come.

Why is this important? Because one of two things have to happen. Either more sovereign debt (Treasuries, Gilts, Bunds, JGBs, etc) have to be issued or the monetary base will expand by the amount of those unborrowed deficits. In the latter case you get inflationary pressures. In the former you get lots more supply of debt instruments. Both tend to equate to higher interest rates over time.

Now if all countries are running deficits and not issuing debt to offset then everyone will see inflationary pressure, but it will tend to be cancelled out in the forex exchange rates. Things like commodities (think gold and oil), however, would tend to see price appreciation.