Unless the Fed continues to raise rates and Congress changes course, the crisis will continue — and the consequences could be dire.
Unless the Fed continues to raise rates and Congress changes course, the crisis will continue — and the consequences could be dire.
T he August inflation numbers are out, with the headline Consumer Price Index (CPI) declining for the second straight month. The headline CPI has now fallen from a peak of 9.1 percent in June, to 8.5 percent in July, and finally down to 8.3 percent in August.
President Biden welcomed the release of these latest BLS data by claiming that they showed “more progress in bringing global inflation down in the U.S. economy.” Markets, however, didn’t seem to be quite so enthusiastic: The S&P 500 sank more than 2 percent on the morning the data were released.
Declining headline inflation is good news, but neither the Federal Reserve nor Congress is off the hook just yet — inflation is still very much out of control. Since the headline CPI primarily reflects transitory fluctuations in the prices of the supply of goods, the declines seen in recent months can be chalked up to the 20 percent drop in the price of oil since June — and not to the Fed’s tightening its belt.
The Fed knows this and will be more concerned with core CPI, the metric that reflects the non-transitory components of inflation by excluding food and energy prices, which fluctuate with supply volatility. Core CPI rose from 5.9 percent in July to 6.3 percent in August. It has been persistently elevated around 6 percent since the start of the year and remains at almost double the rate of Euro Area core inflation, and almost three times the 2015–2019 U.S. average.
A recent economic paper released by the Brookings Institution estimates that in an optimistic scenario, core inflation could be expected to decline to between 2.7 and 4.2 percent by the end of 2024. Under more pessimistic scenarios, however, it could remain firmly above 6 percent well into the future.
As Stanford economist John Cochrane recently noted in the Wall Street Journal, if the conventional view of interest rates and inflation is correct, the Federal Reserve has a long way to go before inflation is brought under control. Advocates of this view argue that the Federal Reserve failed to raise interest rates high enough to quell inflation in the 1970s, and that inflation was only brought under control when interest rates were raised above the rate of inflation for several years in the 1980s.
Under the monetary-policy-targeting rules of another Stanford economist, John B. Taylor, if the Fed wants to bring inflation down to its 2 percent target, interest rates today should be at least 5 percent and potentially as high as 7 percent.
While the Fed is primarily responsible for maintaining low and stable prices, it cannot achieve this goal on its own. Sound fiscal discipline may also be required to anchor inflation expectations.
Last month, at the Fed’s Jackson Hole Economic Symposium, two economists presented an interesting new paper titled “Inflation as a Fiscal Limit.” This paper offered three key takeaways that point to the need for fiscal discipline from Congress as a complement to the Fed’s efforts in taming inflation.
First, large and persistent budget deficits with no perception of debt repayment may lead trend inflation to drift away from the long-run target set by the Fed.
Second, failure to address these fiscal drivers of inflation while the monetary authority subsequently increases rates could result in rising inflation, economic stagnation, and a growing debt burden.
Third, conquering post-pandemic inflation will require mutually consistent monetary and fiscal policies, providing a clear path for both the desired inflation rate and debt sustainability.
Recently, more and more economists have taken a similar view, highlighting the importance of combined fiscal and monetary discipline in taming out-of-control inflation. Fiscal consolidation has always accompanied past policy victories over inflation, whether in the late 1940s or after the 1980–82 recession.
Unfortunately, Congress seems to have little appetite for fiscal discipline and consolidation. The annual rate of federal spending remains elevated at close to $6 trillion. Meanwhile, the Congressional Budget Office forecasts that budget deficits will average 5 percent of GDP over the next decade, 7.3 percent over the following decade, and 10 percent over the decade after that.
While $5 trillion in pandemic-related spending has only worsened our fiscal position, our long-term structural fiscal imbalance is primarily driven by the growth of a handful of entitlement programs created or expanded during the period from 1965 to 1972.
Far from providing a clear path for debt sustainability to anchor inflation expectations, policy-makers in Congress are on track to push our public-debt levels to 185 percent of GDP over the next three decades, assuming no large recessions, unexpected wars, or global pandemics.
Inflation data will vary from month to month, but the priority for fiscal and monetary authorities should not: They must remain laser-focused on reducing and stabilizing core inflation towards the 2 percent target.
Unless the Fed continues to raise rates and Congress implements fiscal consolidation, fiscal and monetary authorities will fail to achieve this goal — and persistently high long-term inflation, economic stagnation, and a potential debt crisis could be the result.