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.