Thursday, July 28, 2022

The Fed Needs Fiscal Help

The Fed Cannot Cure Inflation by Itself, Wall Street Journal June 28 2022

This is the original version, before WSJ edits. They made it shorter, but I think this version is better. 

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

Our inflation stems from fiscal policy.  We are seeing the effects of about $5 trillion of printed or borrowed money, most sent out as checks.  But that alone need not cause inflation. The new money is reserves, which pay interest, and so are equivalent to Treasury debt. The US can borrow and spend without inflation, if people have faith that debt will be repaid, and that Treasury debt is a good investment. Then those who wish to spend will sell it to those who wish to save. With this faith, the US has had many deficits without inflation. The fact that this stimulus led to inflation implies a broader loss of faith that the US will repay debt. 

The Fed’s tools to offset this inflation are blunt.  By raising interest rates, the Fed pushes the economy toward recession. It hopes to push just enough to offset the fiscal boost. 

But an economy with a floored fiscal gas pedal and monetary brakes is not healthy. Our economy is not a simple Keynesian cup, which one can fill or empty with “aggregate demand” from any source.  Raising interest rates can tank asset markets and raise borrowing costs, cutting house building, car purchases, and corporate investment. The Fed can interrupt the flow of credit.  But higher interest rates do not much discourage the consumption spending that fiscal stimulus checks shot off, the desire to spend the government’s money and debt on something. We have at best an unbalanced economy. Our economy needs investment and housing. Today’s demand is tomorrow’s supply.

And slowing the economy is not guaranteed to durably lower inflation anyway. Even in the 2008 recession, with unemployment above 8 percent, core inflation only fell from 2.4% in Dec 2007 to 0.6% in October 2010, and then bounced right back to 2.3% in December 2011. At this rate, even temporarily curing 6% May 2022 core inflation will take an astronomical recession. In 1970 and 1974, the Fed raised interest rates more promptly and more sharply than now, from 4% to 9% in 1970, and from 3.5% to 13% in 1974. Each rise produced a bruising recession. Each lowered inflation. Each time, inflation roared back.

This “Phillips curve,” by which the Fed believes slowing economic activity via interest rates  lowers inflation, is ephemeral. Some recessions and rate hikes even feature higher inflation, especially in countries with fiscal problems.

A Fed-induced slowdown is even less likely to durably lower this inflation. A recession will trigger more stimulus and another financial bail-out. But that’s how we got in this mess in the first place. Those will lead to more inflation. A recession without the expected spending, stimulus, and bailout will be really severe.

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

Our governments are now addressing inflation by borrowing or printing even more money to pay people’s higher bills. That will just make matters 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 just create long lines and worsen supply-chain snafus. Endless dog-ate-my-homework excuses and spin just convince people that our governments have no idea what they’re doing.  

The Fed cannot do it alone. To durably end inflation, the government also has to fix the underlying fiscal problem. Short-run deficit reduction, temporary measures, or accounting gimmicks will not work. A bout of high-tax growth-killing ``austerity’’ will make matters worse. The US has to persuade people that over the long haul of several decades, it will return to its tradition of running small primary surpluses that gradually repay debts. That outcome needs, most of all, economic growth. Tax revenue is tax rate times income. Raising tax rates is like climbing a sand dune, as each rise hurts income growth. Over decades, only the much larger income from the accumulation of growth will work. The US also needs spending reform, especially entitlement reform. And it needs to break the cycle that each crisis will be met by a river of printed or borrowed money, bailouts for finance and stimulus checks for voters.  

Good news: Inflation can end quickly, and without a bruising recession, when there is a joint fiscal, monetary, and economic reform. The adoption of inflation targets by New Zealand, Israel, Canada, and Sweden in the early 1990s are good examples. They included deep fiscal and economic reforms. The sudden end of German and Austrian hyperinflations in the  1920s, when fiscal problems were resolved, are more dramatic examples.  In the US, tight money in the early 1980s was quickly followed by tax, spending, and regulatory reform. Higher economic growth produced large fiscal surpluses by the end of the 1990s. Without those reforms, the monetary tightening might have failed again. If those reforms had come sooner, disinflation might well have been economically painless.  


  1. "Our economy needs investment and housing. Today’s demand is tomorrow’s supply."

    Absolutely. It's infrastructure for society and the economy that serves it. Have to put resources into the right things.

  2. Dr. Cochrane said "The fact that this stimulus led to inflation implies a broader loss of faith that the US will repay debt." Really? Why wasn't it because the stimulus was too large and it dropped newly printed money in the hands of people with zero desire to hold more cash balances? Long term rates haven't jumped up so that argues against the idea that lenders have lost faith in US government debt. I'm fully on board with the need for fiscal rectitude and a more humble role of both the Fed and the US government in the economy but the argument that current inflation is a signal that market participants suddenly feel differently about the US fiscal condition seems week to me.

    1. I guess you could see it this way: they trust it will be repaid, but with newly printed money. The fiscal stimulus doesn't really act as newly printed money immediately, not even when govt debt is purchased by the FED, as long as we trust that the monies will go back to the creditors. Creditors is including the FED, so it isn't *permanent* new money, so that maked no inflation. But what if it is higly implausible that the govt has the resources to repay the market creditors, yet it will still repay them, but only beacuse the FED will keep purchasing. That is permanent new money; hence that is inflation.

      For a more rigorous view on this, there is the Fiscal Theory of the Price Level, about which John Cochrane has written a lot.

  3. I thought we had 3 years of deregulation in 2017-19 and tax cuts in 2017-18 (and new trade deals)/policies. Just like the 1986 tax reform/cut created growth in the nineties...

  4. Help me understand how the stimulus checks of some $1200/household have contributed more to the effects of inflation than the massive unfunded tax cuts of the past 20 years.


    2. 1) Covid spending dwarfed regular deficits.
      2) The checks weren't the main COVID expense. Cochrane is dishonestly lying here.

    3. All the tax cuts - Reagan’s Bush II’s, Trump’s, as well as the cap gains in 1995 - yielded INCREASED tax revenues. Tax cuts are the epitome of self-funding. They all also increased employment, thereby reducing various transfer payments and cutting spending. The problem every time was excessive spending.

    4. Keith,

      "Help me understand how the stimulus checks of some $1200/household have contributed more to the effects of inflation than the massive unfunded tax cuts of the past 20 years."

      Both the $1200/household stimulus checks and the interest payments on federal debt are unearned income.

      The "massive underfunding" that you speak of is a result of large increases in defense spending without commensurate increases in tax revenue.

      And so the $1200/individual stimulus checks, the interest payments on the federal debt, and the defense spending have all contributed to inflation.

    5. Mike,

      Federal tax receipts basically flatlined from 2015-2020 under Trump.

      The Reagan tax cuts were designed so that interest payments on the federal debt would constrain future defense expenditures.

  5. It is interesting that the exclusive reform example that you give is entitlement reform. I’m going to give you the benefit of the doubt and assume you mean all types of entitlements (not just Medicare/Medicaid and SSI for those operating poverty line and working poor). Let’s also remember that CEOs and Boards of many companies who needfully received corporate or industry entitlements during the last two years, are now just as adept spreading ‘irrational pessimism’ as they were are spreading ‘irrational (optimistic) exuberance” while at the same time recording new record profits (from ‘revenue enhancement’) and buying back stock (at the lowest prices in decades). (I am a capitalist by the way, and work as an executive in financial services and technology. I believe a lot of good comes from enterprise and growth but I also witness unfettered capitalistic greed from those companies (including some that I’ve worked diligently to grow) that know they will profit from workers and customers ‘hard landings’). Outside of vague generalities, what would you recommend doing?

  6. "Short-run deficit reduction, temporary measures, or accounting gimmicks will not work. A bout of high-tax growth-killing ``austerity’’ will make matters worse."

    But that's Congress at work: Joe Manchin just agreed to a smaller spending spree along with an increase in corporate taxes.

  7. Well said and while I know all this from days of Reagan Revolution, our current political environment is not likely to allow all of this to happen.

  8. I’m not sure I disagree with the thesis of fiscal inflation—just that I’m not totally convinced.

    My biggest problem is that most people don’t believe it as it’s not really the way economics is generally taught (maybe it’s different among people making the big decisions, but the Fed sure doesn’t believe it wholesale) and inflation is ultimately driven by expectations. So the main thesis is that if ppl don’t think the US will repay debts, then they’ll rush to spend their dollars because they’ll believe the money is less valuable, but that relies on people believing inflation is fiscal, right?

    On the other hand, the stock analogy is somewhat persuasive. I don’t think most stock buyers truly think of the stock value as entirely denoted by future dividends, but prices fluctuate as if they did.

    My theory (or rather like thought to play devil’s advocate) is that people believe inflation is caused by something approximating ability to repay debts. Just like people understand better earnings report= more valuable stock without directly connecting earnings reports to future dividends, they relate government spending bunch of money to inflation without directly factoring in future surpluses.

    I guess, I’d wonder if there’s any situation where a government has spent like drink sailor but also kept pretenses of surpluses. What would be the best evidence that inflation is caused by people’s perception of future surpluses rather than just people’s perception that a government is being stupid, although the two are extremely similar.

    It might have minor implications for Fed interest rate though and the value of messaging because if it’s the latter, the Fed increasing rates, providing reasonable models, and giving reassurance might do something.

  9. How then is Europe's and the UK's inflation rate a tad higher if fiscal policy is at fault?
    Surely our inflation rate downunder should be much higher on your reasoning.

  10. Comments do not appear to be working

  11. Here's an interesting article:

    It amplifies some of what you have said. If I have understood it correctly, monetary policy is not necessarily the only remedy.

  12. Where have all the lessons gone? Long time passing. When will we]ever learn?

  13. "Good news: Inflation can end quickly, and without a bruising recession, when there is a joint fiscal, monetary, and economic reform. The adoption of inflation targets by New Zealand, Israel, Canada, and Sweden in the early 1990s are good examples."

    With respect to Canada, the preliminary fiscal policy work was performed by the imposition of a 7% value-added tax at the federal level on all commodities and services other than food purchases from grocery stores, coupled with mild-to-severe budget cuts by the Liberal government headed by then prime minister Jean Chretien. One doesn't cure inflationary tendencies simply by announcing a target for inflation. The underlying problem in Canada at the time was the federal debt growing rapidly as a result of deficit spending by prior governments, especially Liberal governments during the leadership of former prime minister Pierre Elliot Trudeau in the 1960s, 1970s, and 1980s.

    If ever there was a business case for proving the validity of the fiscal theory of the price level, Canada in the 1960s thru the 1980s and into the 1990s offers furtile grounds for case studies in towards that end.

    Monetary policy and fiscal policy are two sides of the same coin. The fiscal side is the wild card, esp. now given the extreme partisanship in federal, state, and local politics. Risk of failure is high, and the consequences of failure are large. But, who's listening now? Very few.

  14. Historically, Brazil copies the bad examples of the USA and ignores the good ones. Now it seems the opposite, the US is copying the worst mistakes of the Brazilian economy: raising the interest rate to correct inflation without correcting fiscal problems

    1. It seems the Reagan / Volcker administration did exactly that - albeit from a lower baseline amount of federal debt.

      The required fiscal policy changes did not take place until the early 1990's.

  15. Banks are credit creators. In 2010, the PBOC’s RRR went to 18.5% – “to sterilize over-liquidity and get the money supply under control in order to prevent inflation or over-heating”

    All deposit taking, money creating financial institutions, should have uniform legal reserve requirements, for all deposits, in all banks, irrespective of size, both as to types of assets eligible for reserves, as well as the level of reserve ratios. There is no reason for differential reserve requirements in the first place (something Nobel Laureate Dr. Milton Friedman advocated, December 16, 1959).

    FED: “The regulatory limit in Regulation D was the basis for distinguishing between reservable “transaction accounts” and non-reservable “savings deposits.” The Board’s recent action reducing all reserve requirement ratios to zero has rendered this regulatory distinction unnecessary.”

  16. We are not going to right the fiscal ship. You must feel this in your bones.

    Ultimately, politicians should try to shift resources to their constituents so that they have more to work with after the reset.

    The highest ROI use of current resources is anything that increases fertility, especially fertility of the most productive.

  17. I am dubious about the notion of deficits producing inflation. Japan has been running ridiculous deficits and (fortunately so far at least) has relatively tame inflation. (Granted, it also has anemic growth, and I do wonder if the deficits aren’t responsible somewhat for that.)

  18. "The Fed Needs Fiscal Help"

    Or the Fed needs to operate independently of fiscal policy in hitting an inflation target while Congress needs to operate independently of monetary policy in hitting a real GDP growth rate target.


  19. "With this faith, the US has had many deficits without inflation. The fact that this stimulus led to inflation implies a broader loss of faith that the US will repay debt."---JC

    Should the Federal Reserve just hold on to its balance sheet? That would increase faith that federal debts can be honored.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.