Fed rate increases won’t reduce inflation as long as government expenditure remains high, according to the article

TradeGM Analysis date_range August 30th, 2022

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.

As reported by the 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 authors stated that the recent fiscal interventions made in response to the Covid epidemic “have affected the private sector’s assumptions about the fiscal environment, deciding an increase in fiscal inflation while also expediting the recovery.” “Simply tightening monetary policy could not have prevented this spike in inflation.”

Therefore, they continued, the Fed can only successfully stabilize public debt through reliable future fiscal projections. According to the study, rate increases will increase inflation expectations and increase the cost of debt if fiscal spending is not restrained.

Beliefs 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.

According to the report, “it may become increasingly harder for the monetary authority (in this case, the Fed) to stabilize inflation around its preferred target when budget imbalances are large and fiscal credibility wanes.”

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.

The paper states that when budget imbalances are significant and fiscal credibility is lost, “it may become progressively difficult for the monetary authority (in this case, the Fed) to stabilize inflation around its desired target.”

‘A vicious circle’

Without stricter fiscal policies, “a vicious spiral of rising nominal interest rates, rising inflation, economic stagnation, and expanding debt would occur,” the study presented at Jackson Hole cautioned.

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 spending combined with a Fed unwilling to sustain higher interest rates resulted in years of stagflation, or slow growth and rising inflation. That condition remained until then-Fed Chair Paul Volcker led a series of extraordinary rate hikes that eventually dragged the economy into a deep recession and served to contain inflation for the next 40 years.

Will the current inflationary pressures last as long as they did in the 1960s and 1970s? Our investigation highlights the possibility that the upcoming years will be marked by a similar persistent trend of inflation, according to Bianchi and Melosi.

They said, “The risk of sustained high inflation the U.S. economy is experiencing today seems to be better explained by the troubling mix of the massive public debt and the deteriorating fiscal framework.”

Therefore, they added, “the strategy employed to thwart the Great Inflation in the early 1980s may not be efficient now.”

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 will decrease, which will put substantial downward pressure on inflation. According to Ian Shepherdson, chief economist at Pantheon Macroeconomics, “the Fed will be able to breathe more easily if inflation falls quicker than the Fed forecasts over the next several months – that’s our base scenario.

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.

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?

Given that a significant portion of the increase was brought on by a shift in the perceived policy mix, they said, “increasing rates, by itself, would not have stopped the current jump in inflation.” In reality, raising rates without the necessary fiscal support may cause fiscal stagflation. As an alternative, combating post-pandemic inflation necessitates monetary and fiscal policies that are mutually compatible and provide a clear path for both the desired inflation rate and debt sustainability.

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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75.42% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. X