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The Fed’s Inflation-Fighting Rate Hikes Won’t Work as Long as Government Spending Stays High

Logan by Logan
August 30, 2022
in Economy
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The Fed’s Inflation-Fighting Rate Hikes Won’t Work as Long as Government Spending Stays High

Image Source- Getty Images

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Jerome Powell, the head of the Federal Reserve, declared on Friday that the institution has a “unconditional” duty to reduce inflation and that it will “get the job done.”

But according to a study published at the same summit in Jackson Hole, Wyoming where Powell spoke, policymakers can’t handle the situation on their own and might even make things worse by raising interest rates aggressively.

According to experts Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed, inflation in the current situation is mostly being driven by government expenditure in reaction to the Covid problem, and merely raising interest rates won’t be enough to bring it back down.

“The recent fiscal interventions in response to the Covid pandemic have altered the private sector’s beliefs about the fiscal framework, accelerating the recovery but also determining an increase in fiscal inflation,” the authors said. “This increase in inflation could not have been averted by simply tightening monetary policy.”

Therefore, they continued, the Fed “only when public debt can be successfully stabilized by credible future fiscal plans.” According to the study, rate increases will increase inflation expectations and increase the cost of debt if fiscal spending is not restrained.

Image Source- AP Photo/Seth Wenig

Expectations are important

The Fed is primarily responsible for maintaining stable prices, public expectations are important, and the central bank cannot veer from the route it has set out to lower prices, Powell said in his carefully regarded address at Jackson Hole.

Bianchi and Melosi agree that the expectations component is important, but they disagree that the Fed’s promise alone is sufficient.

Instead, they assert that the large levels of federal debt and ongoing government expenditure increases contribute to the public’s belief that inflation will continue to be high. According to USAspending.gov, Congress spent around $4.5 trillion on initiatives associated with COVID. These expenditures led to budget deficits of $3.1 trillion in 2020, $2.8 trillion in 2021, and $726 billion in the first ten months of fiscal 2022 as a result.

As a result, the government debt is currently running at at 123% of GDP, which is still far higher than anything seen since at least 1946, immediately following the World War II spending binge, but is down slightly from the record 128% in Covid-scarred 2020.

“When fiscal imbalances are large and fiscal credibility wanes, it may become increasingly harder for the monetary authority (in this case the Fed) to stabilize inflation around its desired target,” as per the paper.

In addition, the study discovered that if the Fed keeps up its rate-hiking strategy, things might get worse. That’s because higher rates make it more expensive to finance the $30.8 trillion in public debt.

Treasury interest rates have risen as a result of this year’s 2.25 percentage point increase in benchmark interest rates by the Fed. According to Federal Reserve figures, the interest paid on the total debt reached a record $599 billion on an annual basis in the second quarter.

Without stricter fiscal policies, “a vicious circle of rising nominal interest rates, rising inflation, economic stagnation, and increasing debt would arise,” the study presented at Jackson Hole warns.

Powell stated in his remarks that the Fed is making every effort to avoid a situation akin to the 1960s and 1970s, when soaring government expenditure combined with a Fed unwilling to sustain higher interest rates resulted in years of stagflation, or slow growth and rising inflation. This situation remained until Paul Volcker, the then-Chairman of the Federal Reserve, oversaw a series of drastic rate increases that eventually sent the economy into a deep depression and served to control inflation for the following 40 years.

“Will the ongoing inflationary pressures persist as in the 1960s and and 1970s? Our study underscores the risk that a similar persistent pattern of inflation might characterize the years to come,”Melosi and Bianchi wrote.

They also said that “the risk of persistent high inflation the U.S. economy is experiencing today seems to be explained more by the worrying combination of the large public debt and the weakening credibility of the fiscal framework.”

“Thus, the recipe used to defeat the Great Inflation in the early 1980s might not be effective today,” they said.

July saw a slight decrease in inflation, mostly as a result of lower gas costs. However, there was evidence that it was spreading throughout the economy, especially in the prices of food and housing. The consumer price index increased by 8.5% in the previous year. The 12-month pace of 4.4% in July was the highest since April 1983, according to the Dallas Fed’s “trimmed mean” indicator, a preferred gauge of central bankers that ignores extreme highs and lows of inflation components.

However, many economists anticipate that a number of variables will work together to reduce inflation, assisting the Fed in doing its job.

“Margins are going to fall, and that is going to exert strong downward pressure on inflation. If inflation falls faster than the Fed expects over the next few months — that’s our base case — the Fed will be able to breathe more easily,” Pantheon Macroeconomics’ head economist, Ian Shepherdson, wrote the article.

According to Ed Yardeni of Yardeni Research, Powell failed to mention in his address the impact that the Fed’s decision to end its program of asset purchases and raise interest rates has had on the strengthening of the dollar and the weakening of the economy. In terms of a basket of its competitors, the dollar on Monday reached its highest level in nearly 20 years.

“So [Powell] may soon regret having pivoted toward a more hawkish stance at Jackson Hole, which soon may force him to pivot yet again toward a more dovish one,” Yardeni wrote.

However, the Bianchi-Melosi study emphasized that bringing down inflation will require more than just a promise to hike rates. What might have happened if the Fed had begun raising interest rates earlier, rather than rejecting inflation as “transitory” and not requiring a policy response for most of 2021?

Tags: A vicious circleaggressive interest rate increasesahead of rising interest ratesCovid crisisCovid pandemiccurb inflationeconomic stagnationExpectations matterFed rate hikesFederal Reservefiscal credibilityfiscal imbalancesfiscal inflationfiscal spendingGDPgovernment debt becomes more costly to financegovernment spending stays highgross domestic producthigh levels of federal debthigher ratesincrease in inflationincreasing debt would ariseInflationInflation In USinflation is being driveninflation risinginflation will remain highJerome Powellmonetary authorityraising interest ratesrecessionresponsibility to ease inflationRising costsrising energy costsrising inflationrising interest ratesrising material costsrising nominal interest ratesrisk of persistent high inflationslow growthstabilize inflationstagflationsustain higher interest ratestightening monetary policytighter fiscal policiesUS Newsweakening credibility of the fiscal framework
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