John C. Williams, President and CEO of the Federal Reserve Bank of New York, Lael Brainard, Vice Chairman of the Federal Reserve Board, and Jerome Powell, Chairman of the Federal Reserve, walk in Teton National Park where financial leaders from around the world gathered in Jackson Hole Economic Symposium outside Jackson, Wyoming, August 26, 2022.
Jim Urquhart | Reuters
Federal Reserve Chairman Jerome Powell proclaimed on Friday that the central bank has an “unconditional”[ads1]; responsibility for inflation and expressed confidence that it will “get the job done.”
But a paper released at the same Jackson Hole, Wyoming summit where Powell spoke suggests the Fed can’t do the job alone and may actually make matters worse with aggressive rate hikes.
In the current case, inflation is largely driven by fiscal spending in response to the Covid crisis, and raising interest rates will not be enough to bring it back down, researchers Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed wrote in a white paper released on Saturday morning.
“The recent fiscal interventions in response to the Covid pandemic have changed the private sector’s faith in 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 tightening monetary policy.”
The Fed can then bring down inflation “only when public debt can be stabilized with credible future fiscal plans,” they added. The article suggests that without limits on fiscal spending, interest rate increases will make debt costs more expensive and increase inflation expectations.
In his closely watched Jackson Hole speech, Powell said the three main principles informing his current views are that the Fed is primarily responsible for stable prices, public expectations are critical, and the central bank cannot give in to the path it has drawn to lower rates. .
Bianchi and Melosi argue that a commitment from the Fed is simply not enough, although they agree on the expectation aspect.
Instead, they say, high levels of federal debt, and continued government spending increases, are helping to fuel the public perception that inflation will remain high. Congress spent about $4.5 trillion on Covid-related programs, according to USAspending.gov. These outlays 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 through the first 10 months of fiscal year 2022.
Consequently, the federal debt is around 123% of GDP – down slightly from the record 128% in the Covid-scarred 2020, but still well above anything seen going back to at least 1946, right after World War II.
“When fiscal imbalances are large and fiscal credibility declines, it may become increasingly difficult for the monetary authorities,” in this case the Fed, “to stabilize inflation around the desired target,” the paper said.
Moreover, the research found that if the Fed continues down its rate hike path, it could make matters worse. That’s because higher interest rates mean the $30.8 trillion in national debt will be more expensive to finance.
As the Fed has raised benchmark interest rates by 2.25 percentage points this year, government yields have risen. In the second quarter, interest paid on total debt was a record $599 billion at a seasonally adjusted annual rate, according to Federal Reserve data.
“An evil circle”
The paper presented at Jackson Hole warned that without tighter fiscal policy, “a vicious cycle of rising nominal interest rates, rising inflation, economic stagnation and rising debt would ensue.”
In his remarks, Powell said the Fed is doing everything it can to avoid a scenario similar to the 1960s and 70s, when rising government spending combined with a Fed unwilling to maintain higher interest rates led to years of stagflation, or slow growth and rising inflation. That state of affairs persisted until then-Fed Chairman Paul Volcker presided over a series of extreme rate hikes that eventually dragged the economy into a deep recession and helped tame inflation for the next 40 years.
“Will the ongoing inflationary pressures persist as in the 1960s and 1970s? Our study underscores the risk that a similar persistent inflationary pattern could characterize the coming years,” Bianchi and Melosi wrote.
They added that “the risk of sustained high inflation facing the US economy today appears to be explained more by the worrisome combination of the large public debt and the weakened credibility of the fiscal framework.”
“Therefore, the recipe used to defeat the great inflation of the early 1980s may not be effective today,” they said.
Inflation eased somewhat in July, mainly thanks to a drop in petrol prices. However, there was evidence that it was spreading in the economy, particularly in food and rent costs. In the past year, the consumer price index has risen by 8.5%. The Dallas Fed’s trimmed mean indicator, a favorite gauge of central bankers that throws out extreme highs and lows of inflation components, registered a 12-month pace of 4.4% in July, the highest reading since April 1983.
Still, many economists expect several factors to conspire to bring down inflation and help the Fed do its job.
“Margins are going to fall, and that’s going to put 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 easier,” wrote Ian Shepherdson , chief economist at Pantheon Macroeconomics.
Ed Yardeni of Yardeni Research said Powell did not acknowledge in his speech the role that Fed hikes and the reversal of the asset purchase program have had in strengthening the dollar and slowing the economy. The dollar hit its highest level in nearly 20 years on Monday against a basket of peers.
“So [Powell] may soon regret swinging toward a more hawkish stance at Jackson Hole, which may soon force him to swing once more toward a more dovish one,” Yardeni wrote.
But the Bianchi-Melosi paper indicates that it will take more than a commitment to raise interest rates to bring down inflation. They broadened the argument to include the what-if question had the Fed started hiking earlier, having spent much of 2021 dismissing inflation as “transient” and not warranting a policy response.
“Rising rates by themselves would not have prevented the recent rise in inflation, given that [a] much of the increase was due to a change in the perceived policy mix,” they wrote. “In fact, rising interest rates without appropriate fiscal support can result in fiscal stagflation. Instead, conquering post-pandemic inflation requires a mutually consistent monetary and fiscal policy that provides a clear path for both the desired inflation rate and debt sustainability.”