Is the Federal Reserve harming the economy to save us from inflation or is Congress harming us with endless spending stimulus? We know that the Fed completely misjudged the post-Pandemic inflation. We see Congress narrowly passing several trillion-dollar stimulus bills and now the new budget. Is it the Fed or is it Congress?
The Economist, an insightful British news magazine, in a recent Special Report (October 8, 2022. pp 1-12. For all quotes here) warns America’s Keynesian-oriented Congress about over-reliance on fiscal stimulus while noting the Fed’s Jerome Powell is “penitent as global inflation has both arisen and persists.” Because the Fed was caught off guard by inflation, it has raised interest rates sharply and suddenly. Is it enough? Rather than clearly assessing blame, they note that U.S. monetary and fiscal policy are moving in opposite directions.
While the Fed takes the blame, it looks like the Inflation Reduction Act and the 2023 federal budget “guarantee that the U.S. will have an annual budget deficit of 5% of GDP for a decade.” The short-sightedness here is not only the size of budget deficits, but also how they stimulate the economy. Where does the money go? A half-trillion dollars goes toward subsidies for decarbonization to combat climate change. We should be concerned about the ‘picking winners’ aspects of these subsidies (politely called an industrial policy), but the focus should be on avoiding both more inflation and a deep recession.
We live in times when all economies are interconnected, though we are disconnecting for security reasons. The supply shocks, famously those shipping containers, have almost ended, but that will not be enough to end inflation and stabilize the economy. The mostly soaring costs of energy, another result of ‘picking’…this time picking losers (oil companies) are not ending.
The Economist notes, “It is not within the gifts of governments to stop the economic pain they cause.” How to keep the government from making things worse? Two ideas and two evaluations:
Congress can act responsibly. The Economist further notes that the 2010 Simpson-Bowles Plan would have nearly balanced the budget, keeping our deficit at 66% of GDP. Ignoring the deficit is taking us to 105% of GDP. Foolishly, it is fashionable to no longer worry about public debt or excessive spending. ‘Modern Money Theory’ says we can spend till we get inflation. We have inflation but have not stopped spending. Congress is focused on the goal of ‘dividing the pie’ redistribution rather than on growth. Sadly, growth falters.
The Fed can act responsibly too. We recognize that since the 2008 Great Recession, we have had very low interest rates. When you can borrow at 0%, money is free, and there is no reason not to fund almost any project regardless of its profitability. It’s even worse when the inflation-adjusted rates are below 0%. How? If interest rates are 5% and inflation is 7% then the real interest rate is minus 2%. Better than free. This grand experiment, along with expanding the money supply (by 60% since Covid) and further complicated by the Fed adding to the ‘balance sheet’ by buying trillions of U.S. treasury bonds, are also novel. All clever ideas in the short run, but it’s been almost 15 years and we are just now unwinding all that and facing the facts of those hyped investments.
Right now, the Fed is getting it right. They are unwinding that balance sheet, holding the money supply constant (amazingly constant since 2022), raising the interest rates (harming the housing market and causing food bills to soar), and making it clear that they will stick with this medicine even though the President and Congress have resisted and conveniently blame Putin’s invasion of Ukraine. (Pray for the Ukrainians)
Right now, Congress is getting it wrong. “The trouble is that even fiercely independent central banks cannot force politicians to keep their budgets in order.” Spending on decarbonizing the economy is proceeding at a pace that seems motivated by a near-religious zeal. Congress is also insisting that we ‘buy American,’ which offends (as it should) our trading partners. Bottom line: Congress listens intently to economists when they say, “Spend,” but becomes deaf when the same economists say, “Stop!”
Conclusion: Let me quote the Economist once more so you’ll know that this is not my rant. “(W)ithout greater back up from fiscal policy, central banks risk ‘fiscal stagflation,’ in which higher interest rates kill short-term growth but, owing to the lack of budgetary backing, prove unable to bring inflation down.” As delusional as the Fed has been, they are owed a debt of gratitude for being the last bastion of sanity in a political world of fiscal excesses.