Fed rate hikes won’t curb inflation if spending stays high, paper says

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John C. Williams, president and chief executive officer of the Federal Reserve Bank of New York, Lael Brainard, vice chairman of the Federal Reserve Board of Governors, and Jerome Powell, chairman of the Federal Reserve, hiking in Teton National Park where financial leaders from around the world gathered for the Jackson Hole Economic Symposium outside Jackson, Wyoming, August 26, 2022.

Jim Urquhart | Reuters

Federal Reserve Chairman Jerome Powell said Friday that the central bank has an “unconditional” responsibility for inflation and expressed confidence that it “will get the job done.”

But a paper published at the same Jackson Hole, Wyoming summit where Powell spoke suggests the Fed can’t do the job itself and could actually make things worse with aggressive rate hikes.

In the current case, inflation is largely driven by fiscal spending in response to the Covid crisis, and just raising interest rates will not be enough to bring it back, researchers Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed wrote in a white paper released Saturday morning.

“Recent fiscal interventions in response to the Covid pandemic have changed private sector views on 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 prevented simply by tightening monetary policy.”

So the Fed can only cut inflation “if government debt can be successfully stabilized through credible future fiscal plans,” she added. The paper suggests that interest rate hikes, without limits in fiscal spending, will make the cost of debt more expensive and raise inflation expectations.

Expectations are important

In his closely followed Jackson Hole speech, Powell said the three main principles that support his current views are that the Fed is primarily responsible for stable prices, that public expectations are critical and that the central bank cannot deviate from the path it has taken to lower prices. .

Bianchi and Melosi argue that a commitment from the Fed is simply not enough, although they do agree on the expectation aspect.

Instead, they say high levels of federal debt and continued increases in government spending are helping fuel the public perception that inflation will remain high. Congress has spent about $4.5 trillion on Covid-related programs, according to USAspending.gov. That spending resulted in a budget deficit of $3.1 trillion in 2020, a deficit of $2.8 trillion in 2021 and a deficit of $726 billion in the first 10 months of fiscal 2022.

As a result, federal debt is around 123% of GDP – slightly below the record 128% in Covid-ravaged 2020, but still well above anything we’ve seen dating back to at least 1946, right after the spending boom of the year. the second World War.

“If fiscal imbalances are large and fiscal credibility diminishes, it could become increasingly difficult for the monetary authority, in this case the Fed, to stabilize inflation around the desired target,” the paper said.

In addition, the study found that if the Fed continues with its rate hikes, it could make matters worse. That’s because higher rates mean the $30.8 trillion in government debt becomes more expensive to finance.

Since the Fed has raised benchmark interest rates by 2.25 percentage points this year, Treasury interest rates have soared. In the second quarter, interest paid on total debt hit a record $599 billion annualized, seasonally adjusted, according to data from the Federal Reserve.

‘A vicious circle’

The paper presented at Jackson Hole warned that without tighter fiscal policies, “a vicious circle of rising nominal interest rates, rising inflation, economic stagnation and mounting debt would ensue.”

In his comments, Powell said the Fed is doing everything it can to avoid a scenario akin to the 1960s and 1970s, when rising government spending combined with a Fed unwilling to hold higher interest rates led to years of of stagflation, or slow growth and rising inflation. That situation lasted until then-Fed Chairman Paul Volcker led a series of extreme rate hikes that eventually pushed the economy into a deep recession and helped tame inflation over the next 40 years.

“Will persistent inflationary pressures continue as they did in the 1960s and 1970s? Our study underscores the risk that a similar sustained inflation pattern could characterize in the coming years,” Bianchi and Melosi wrote.

They added that “the risk of continued high inflation currently facing the US economy appears to be more explained by the worrying combination of high government debt and the diminishing credibility of the fiscal framework.”

“So the recipe used to beat Great Inflation in the early 1980s may not be effective today,” they said.

Inflation cooled slightly in July, largely due to a fall in gasoline prices. However, there were indications that it was spreading in the economy, particularly in food and rent costs. The consumer price index has increased by 8.5% in the past year. The Dallas Fed’s “cropped average” indicator, a central bankers’ favorite measure that throws out extreme highs and lows of inflation components, registered a 12-month pace of 4.4% in July, its highest level since April 1983.

Still, many economists expect several factors to conspire to bring inflation down, allowing the Fed to do its job.

“Margins are going to fall and that will put strong downward pressure on inflation. If inflation falls faster than the Fed expects in the coming months – that’s our base case – the Fed will be able to breathe easier,” he wrote. Ian Shepherdson, chief economist at Pantheon Macroeconomics.

Ed Yardeni of Yardeni Research said Powell in his speech failed to acknowledge the role the Fed’s hikes and the rollback of its asset purchase program have played in strengthening the dollar and slowing the economy. The dollar hit its highest level in nearly 20 years on Monday compared to a basket of its counterparts.

“So [Powell] will soon regret turning to a more aggressive stance at Jackson Hole, which may soon force him to turn to a more deaf stance one more time,” Yardeni wrote.

But the Bianchi-Melosi paper indicates that it will take more than a pledge to raise interest rates to curb inflation. They expanded the argument to include the what-if question if the Fed had started walking earlier, after dismissing inflation as “transient” for much of 2021 and justifying no policy response.

“Raising rates by itself would not have prevented the recent rise in inflation, as [a] much of the increase was due to a change in perceived policy mix,” they wrote. “In fact, raising rates without proper fiscal support could lead to fiscal stagflation. Instead, overcoming post-pandemic inflation requires mutually consistent monetary and fiscal policies that provide a clear path to both desired inflation and debt sustainability.”

The Valley Voice
The Valley Voicehttp://thevalleyvoice.org
Christopher Brito is a social media producer and trending writer for The Valley Voice, with a focus on sports and stories related to race and culture.

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