Filling the Punch Bowl
Reckless spending is undermining the Fed’s efforts to get inflation under control.
Economic data continue to indicate that we’re in for a long period of elevated inflation. Commonly used measures like median Personal Consumption Expenditures and Consumer Price Index inflation are running, respectively, at annualized rates of about 4 percent and 5 percent over the past few months. Moreover, with April’s release of the highest-quality wage data available showing employee compensation growing at 4.8 percent annualized in the first quarter, good reasons exist to expect inflation to remain stubbornly high. Continued reckless government spending is one of them.
In response to persistently high inflation, the Fed’s hiking cycle, bringing rates to roughly 5 percent, is the fastest and most aggressive in 40 years. Yet we’ve seen very limited evidence of a slowdown in economic growth sufficient to bring inflation back down to the 2 percent target.
Many of the economists predicting that the Fed’s rate hikes will bring a recession think the lags are just longer than normal this cycle. Housing is one of the biggest drivers of business-cycle volatility, and the time from starting a construction project to completing it has expanded significantly due to problems obtaining sufficient building materials and labor. Despite recent declines by more than 20 percent in housing starts, housing units under construction remain just 2 percent off their all-time highs. Builders haven’t laid off construction workers in the way that would typically usher in the start of a recession, because they’re still working on projects started a long time ago.
Meantime, after the failure of Silicon Valley Bank, concerns linger over how much of a drag banking problems will exert on the economy. Fed Chair Jerome Powell has estimated that banking stress provides the same degree of economic restraint as an additional quarter-point of higher rates, while private-sector economists’ estimates run twice that. Indeed, with fixed-income markets pricing roughly 1.5 percent worth of Fed cuts over the next year, the implicit probability of a material recession setting in is well above zero. Some private-sector forecasters even put the odds of a recession in the next year at 99 percent.
The market’s high recession odds might be correct. Banking stresses could trigger it, a result of the lagged effects of monetary policy. But markets also tend to underestimate the effects of fiscal policy on the economy, and high government spending is still going full steam ahead. Recent years have painfully retaught the lesson that monetary policy is a useful tool, but fiscal policy is a far more powerful one and therefore should be used sparingly. Arguably, the central bank’s interest rate hikes have just been scrambling to catch up to Treasury outlays. Fiscal policy, in other words, is still working at cross-purposes with monetary policy.
Tens of billions of dollars from the Infrastructure Investment and Jobs Act (IIJA) and the semiconductor-boosting CHIPS Act are starting to make an impact. While broad bipartisan consensus persists that the nation needs to invest in its infrastructure and in the resilience of its critical technology-supply chains, there are better and worse times to do so. These outlays should be taken at a time other than when inflation is running way too high and unemployment is at rock bottom.
Worse, while Democrats initially expected the environmental subsidies in the (grossly misnamed) Inflation Reduction Act (IRA) to cost about $300 billion, the latest scoring from the Congressional Budget Office indicates that the subsidies are likelier to boost the cumulative deficit in coming years by $569 billion—almost twice the initial estimate. These outlays encourage construction of facilities to take advantage of the free money when there is no slack in the economy to absorb that demand, thereby boosting inflation and crowding out private sector activity. Regardless of whether you think climate change in 2100 requires government action, it will be little affected by delaying subsidies for items like sustainable aviation fuel until inflation is a bit lower.
Economists typically argue that policy should “lean against the wind” by being contractionary when inflation is high and stimulative when inflation is low. The fact that these fiscal expenditures are making their way out of the Treasury when inflation has been running at four-decade highs is an embarrassingly stupid policy error.
Crucially, the longer inflation remains elevated, the higher the odds that elevated inflation expectations get embedded in consumer and business psychology, damning us with high inflation for many years to come unless we endure an extremely painful recession. That’s why it’s critical to get inflation down as quickly as possible. Dovish economists, who tend to be more tolerant of high inflation, want to avoid a recession and are less concerned with the risks of inflation becoming ingrained. The Federal Reserve, staffed mostly by dovish economists, has indicated it expects to end its rate-hiking cycle soon, after its May hike.
A top priority should be to stop fiscal policy from pushing inflation higher and undermining the effects of Fed tightening. The Biden administration has the power to delay IIJA, CHIPS, and IRA outlays, and should do so rather than pumping yet more juice into an already highly inflationary economy. But given the administration’s politics, there’s little hope of that occurring.
Absent fiscal responsibility from the White House, Congress should impose it. The House of Representatives has passed the Limit, Save, Grow Act, which attempts to do so. Enacting cuts to the IIJA and IRA expenditures—or at the very least delaying outlays—would be a significant step toward reducing the fiscal impulse for inflation. Given the inflationary backdrop, keeping fiscal policy at current settings is terrible policy.
Photo by SAUL LOEB/AFP via Getty Images
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