Student Debt Changes Would Boost Inflation
The student debt cancellation and relief measures announced earlier this week by the Biden Administration would cost around $500 billion over a decade and would meaningfully boost inflation. Assuming current economic conditions continue and increased spending mostly flows through to prices, we estimate these changes would boost inflation by 15 to 27 basis points over the next year.
The package of student debt changes will likely be even more inflationary than extending the student debt pause for another year, which we estimate would have boosted inflation by 15 to 20 basis points. The inflationary effect of these changes will more than undermine gains from the Inflation Reduction Act. They also make it more difficult for the Federal Reserve to fight inflation, increasing the amount they must raise rates and elevating the chance that the economy ends up in a recession.
The announced changes include $10,000 of student debt cancellation for most borrowers and another $10,000 for those who received Pell Grants, a four month extension of the pandemic-era emergency repayment pause, and expansions of the income-driven repayment (IDR) program. We've estimated these policies will cost the federal government $440 billion to $600 billion on a present value basis, though the lost cash flow will be much smaller over the next few years.
Increased cash flow and higher net wealth as a result of these changes will lead households to increase their consumption. In a relatively healthy economy operating near its long-term potential, this increased consumption would boost output more than it boosts prices and might increase Personal Consumption Expenditure (PCE) prices by 6 to 10 basis points, assuming a 33 percent price pass-through. However, if demand remains well in excess of supply as it has over the past 18 months, most of that higher consumption will flow through to higher prices.
Assuming 90 percent of higher consumption flows through to prices, we estimate the announced student debt changes – which would cancel about one-third of all student debt – will boost PCE inflation by 15 to 27 basis points. This is consistent with our past analysis of the economic and inflationary effects of full and partial student debt cancellation, though (unlike in 2020 and 2021) it assumes an economy operating above its short-term potential and includes a somewhat wider band in estimating the wealth effect.
How Will the Student Debt Changes Boost Inflation?
The student debt changes will increase inflation in three ways – by reducing the amount of income households use to pay down debt over the next year, by increasing household wealth, and by putting upward pressure on tuition costs.
The changes will end payments for four months for all borrowers and in perpetuity for nearly half of them, thereby boosting household cash flow. Most remaining borrowers will see lower payments as a result of reduced debt burden and – ultimately – changes to the IDR program. Overall, we estimate student debt payments over the next 12 months will be roughly $50 billion lower as a result of the announced changes. We assume the debt cancellation will be distributionally similar to COVID rebate checks and thus have a similar consumption multiplier of 0.5x to 0.6x; the consumption multiplier for the overall pause will be substantially lower.
The changes will also boost household net wealth by $10,000 or $20,000 per borrower in many cases. The economic literature suggests consumers will spend a portion of that higher wealth – about 3 to 6 percent – on new or accelerated purchases. Our analysis assumes 2 to 5 percent is spent over the first year. Consistent with our estimates of the output effect of debt cancellation, we assume households will behave as if their wealth has increased by the full amount of cancelled debt. However, we assume no wealth effect from higher promised future forgiveness under the IDR program.
Finally, debt cancellation may drive up tuition prices by creating the expectation (and in the case of IDR, promise) of future debt cancellation, thereby increasing willingness to borrow among prospective students. Studies have shown that these effects can lead students and parents to be less sensitive to the cost of tuition, which could encourage colleges and universities to further hike tuition and fees. Importantly, our analysis does not account for these effects.
Isn't Ending the Repayment Pause Disinflationary?
Many have claimed the announced changes won't add to inflation because they are relatively less inflationary than simply continuing the current repayment pause for another year. However, our analysis finds the opposite is true, and that the changes will likely be more inflationary than continuing the repayment pause. We estimate the policies put forward – which themselves include a four-month extension of the pause – would add 15 to 27 basis points to the inflation rate, assuming 90 percent price flow-through. A year-long extension of the pause would add 15 to 20 basis points to the inflation rate.
More fundamentally, the claim that the changes will be disinflationary relies on a baseline trick and an invalid comparison. The student debt repayment pause was a temporary, emergency, and pandemic-era policy designed to support households during the worst parts of the economic downturn caused by COVID-19. It was scheduled to end on August 31 (after having been needlessly extended), and the appropriate way to measure the President's proposal is relative to that scheduled expiration. Any other comparison is inconsistent with the law, with the design of student loans as loans rather than grants, and with claims made in support of the new policy announcement. If one wants to claim the new debt cancellation policy will reduce inflation (or increase it only modestly), one must also argue that the proposals will increase overall loan collection dramatically and would therefore ultimately represent a cost, not a benefit, to borrowers.
Federal Reserve Responses Could Blunt Inflation while Triggering a Recession
The Federal Reserve can offset the inflationary effect of the student debt changes over time by raising interest rates or otherwise tightening monetary policy. Depending on the timing of such actions, it might reduce the inflationary effect by about a quarter in the first year and erase it over time. Higher interest rates, however, have significant economic consequences.
Former Council of Economic Advisers Chair Jason Furman has estimated that the Fed would need to raise interest rates by 0.5 to 0.75 percentage points more than planned to counteract the inflationary impact of the package. These higher rates would flow through to mortgages, car loans, and even future student loans – not to mention federal interest costs. By discouraging consumption and investment and reducing housing and other wealth, higher rates will also temper economic output and could lead to higher unemployment.
With inflation at a 40-year high, the Federal Reserve already has its work cut out for it in navigating a "soft landing" that avoids an economic downturn. If fiscal policy works against as opposed to with the Fed, it will increase the likelihood of a recession.
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Our analysis finds that the President's latest student debt policies would likely boost the inflation rate by 15 to 27 basis points over the next year – between a sixth and a quarter point increase – at a time when inflation is already surging at a 40-year high.
Different analysts may disagree on the magnitude of the inflationary effect of the President's debt cancellation proposal. But the direction is indisputable – the plan will add to overall inflationary pressures and thus make the Fed's job of wringing out inflation without causing recession even more challenging.