The Fed needs fiscal help

The Fed cannot cure inflation alone, Wall Street newspaper June 28, 2022

This is the original version, before the WSJ changes. They have shortened it, but I think this version is better.

The Fed cannot cure this inflation alone. Relying on it to do so will only lead to stagflation cycles.

Our inflation comes from fiscal policy. We are seeing the effects of about $ 5 trillion in printed or borrowed money, most of it sent as checks. But this alone must not cause inflation. The new currency is reserves, which pay interest, and therefore are equivalent to the debt of the Treasury. The United States can borrow and spend without inflation, if people are confident that the debt will be repaid and that Treasury debt is a good investment. Then those who want to spend will sell it to those who want to save. With this faith, the United States has had many deficits without inflation. The fact that this stimulus has led to inflation implies a wider loss of confidence that the US will pay off the debt.

The Fed’s tools to offset this inflation are blunt. By raising interest rates, the Fed pushes the economy into recession. He hopes to push hard enough to offset the fiscal push.

But an economy with a grounded fiscal gas pedal and monetary brakes is not healthy. Our economy is not a simple Keynesian cup, which can be filled or emptied with “aggregate demand” from any source. Rising interest rates can ruin asset markets and raise borrowing costs by reducing home construction, car purchases, and business investments. The Fed can stop the flow of credit. But higher interest rates don’t discourage much the consumer spending that tax incentives have fired, the desire to spend the money and government debt for something. We have at best an unbalanced economy. Our economy needs investment and housing. Today’s demand is tomorrow’s supply.

And the slowdown in the economy is not guaranteed to bring down inflation in a lasting way anyway. Even in the 2008 recession, with unemployment above 8%, core inflation only fell from 2.4% in December 2007 to 0.6% in October 2010, and then climbed back to 2.3%. in December 2011. At this rate, even temporarily cured by 6% Core inflation in May 2022 will experience an astronomical recession. In 1970 and 1974, the Fed raised interest rates more quickly and more sharply than now, from 4% to 9% in 1970 and from 3.5% to 13% in 1974. Each increase produced a bad recession. . Each lowered inflation. Each time, inflation roared again.

This “Phillips curve”, by which the Fed believes that the slowdown in economic activity through interest rates reduces inflation, is ephemeral. Some recessions and rate hikes are even characterized by higher inflation, especially in countries with fiscal problems.

A Fed-induced slowdown is even less likely to reduce this inflation on a lasting basis. A recession will trigger more stimulus and another financial bailout. But that’s how we got into this mess in the first place. Those will lead to higher inflation. A recession without the expected spending, stimulus and bailout is going to be really bad.

Higher interest rates will directly worsen deficits by adding to the cost of interest on debt. In 1980, the federal debt was less than 25% of GDP. Lowering inflation was hard enough. It is now over 100%. Each higher interest rate percentage point means $ 250 billion more in inflation-inducing deficit.

Our governments are now tackling inflation by borrowing or printing even more money to pay people’s higher bills. This will make things worse. A witch hunt for “greed”, “monopoly” and “profiteers” will fail, as it has for centuries. Price controls or political pressure to lower prices will only create long lines and worsen supply chain kinks. Endless excuses and excuses for doing homework simply convince people that our governments have no idea what they are doing.

The Fed cannot do it alone. To end inflation in a lasting way, the government must also solve the underlying fiscal problem. Short-term deficit reduction, temporary measures or accounting gimmicks will not work. An “austerity” attack that kills growth and high taxes will make matters worse. The United States must persuade people that in the long run of several decades they will return to their tradition of managing small primary leftovers that gradually pay off debts. This result needs, above all, economic growth. Tax revenue is the tax rate multiplied by the income. Raising tax rates is like climbing a sand dune, as any increase hurts income growth. Over the decades, only the much larger income from the accumulation of growth will work. The United States also needs spending reform, especially rights reform, and it needs to break the cycle that every crisis will be dealt with by a torrent of printed or borrowed money, financial bailouts and security checks. stimulus for voters.

Good news: Inflation can end quickly and without a bad recession when there is a common fiscal, monetary and economic reform New Zealand, Israel, Canada and Sweden adopted inflation targets in the early 1990s I’m a good example of this. They included profound fiscal and economic reforms. The sudden end of German and Austrian hyperinflation in the 1920s, when the fiscal problems were resolved, are more dramatic examples. In the United States, monetary tightening in the early 1980s was quickly followed by fiscal, spending and regulatory reform. By the late 1990s, increased economic growth produced large budget surpluses. Without these reforms, monetary tightening could have failed again. If those reforms had come earlier, disinflation could very well have been economically painless.