In his Wall Street Journal Op-Ed President Biden outlined a three-pronged plan to combat the current inflation rate:
- The Fed – the institution that, as he mentioned, has primary responsibility to control inflation.
- Take practical steps to make things more affordable and boost the productive capacity of our economy over time.
- Keep reducing the Federal deficit, which will help ease price pressures.
But what should we expect as the administration implements its three-pronged approach?
To those of us who believe that inflation is a monetary phenomenon, it is nice to see the President correctly pointing out that the Fed has a primary responsibility and ability to control inflation. If, as we believe, inflation is a monetary phenomenon, then the blame for the inflation rate lays at the feet of the Fed, not the administration. This is one instance when the President may legitimately claim that the bad outcome is not his fault. The Fed’s actions have been aligned with the administration’s objectives today, but will that continue?
During the crisis and its aftermath, the Fed did play ball with the administration. It expanded its balance sheet and bought most of the newly minted Treasury securities. The Fed also financed the Federal government and, in the process, monetized the deficit. We contend that the balance sheet expansion led to an excess supply of money and resulted in the current inflation bout. We do not know why the Fed took the actions that it did, but the deficit financing effectively made the Fed an appendage of the Treasury. The data in Figure 1 shows the correlation between the deficit and the inflation rate under the Powell Fed. It suggests that the Fed did in fact monetize the deficit.
Since his reappointment to a second term at the helm of the Fed, Jerome Powell has announced a balance sheet reduction. The scheduled sale of the bonds will restore the Fed’s independence and reduce the monetization of the budget deficit; a bullish outcome that should result in a reduction in the inflation rate. Will this reclaimed independence of the Fed be seen as positive or negative by the Administration? This likely depends on the outcome. Like all things, time will tell.
Taking practical steps to make things more affordable and boost productive capacity
The second prong of the President’s plan to fight inflation may be laudable but it will not have a significant impact on the inflation rate. First, a relative price increase need not be inflationary. One only needs to go back to the commodity super cycle early during the millennium to find evidence of this. During the super cycle, the price of several commodities, such as oil, increased several folds (see Figure 2) and yet the inflation rate remained below the 4% range (Figure 3).
Neither the unemployment rate nor oil prices provide an explanation for the US inflation rate during the last three decades. In contrast, the difference between the growth in the money supply, M2, and the change in money demand provides us with a measure of the excess money supply; that does a surprisingly excellent job of explaining the low underlying inflation rate during the period (Figure 4). In the graph below, the blue line represents the supply of money, and the red line represents the demand for money – you can see that supply has far exceeded demand since Q2 2021.
The data supports the view that inflation is a monetary phenomenon. If that is the case, there are some clear policy implications. One being that the Fed and its policies are the key determinants of the underlying inflation rate. Another being that any attempt to control or regulate prices will be futile and will only result in distorting the economy. And finally, that at best the administration can have an indirect and adverse effect on the underlying inflation rate to the extent its policies slow down the economy. The dirigiste agenda that the administration is proposing will only result in wage and price controls that will further distort the economy and destroy incentives to work, produce and invest.
The president is correct in pointing out that the elevated price at the pump is in part because Russian oil, gas, and refined product are off the market (this is a textbook supply shock), that we cannot let up on our global effort to punish Mr. Putin for what he has done, and that we must mitigate these efforts for American consumers. All of these statements make sense; however, the President does not mention the bad US policies that contributed to the current situation. Yes, oil is a global product, and the price is determined in the global markets, but let’s step back and look at the policies that we and our partners have adopted during the last few years. Germany’s green energy policy led to the shutdown of nuclear and coal generating plants. This increased Germany’s dependency on imported natural gas which came from Russia. In the US we have seen similar policies; nuclear power plants closing or scheduled to close, and the regulatory burden making it more difficult to extract and bring to market fossil fuels. The Western world governments made a concerted effort to reduce their production of fossil fuels and nuclear energy, both laudable goals. But the price paid was an increased global dependency on Russian energy. Rather than reversing some of these policies, as Germany is doing, the Biden administration has doubled down on its green energy initiatives. While this may accelerate the transition to the more eco-conscious world the administration foresees, the transition is unnecessarily more painful. Even worse, the Administration has chosen to attempt to solve a distorting policy that discouraged the supply of domestic fuels with a further distortion of the market by attempting to enact price controls and or subsidies to the consumers.
The President is a true dirigiste. He is proposing a series of measures, such as his Housing Supply Action Plan, to increase the supply of affordable housing. But if history is a guide, we know that the government programs that are supposed to be “profitable” end up being more expensive and less profitable than initially projected. The government is not an efficient provider of goods that compete with private sector goods. Just think about education – the public schools could be run better. And it is not necessarily a lack of resources, for one may be able to find less expensive and better alternatives produced by the private sector, such as charter schools, parochial schools, etc. The baby formula crisis is another example. Yes, there was a plant that produced a sizable portion of the baby formula in the US. The President invoked the Defense Production Act, and it is nice to see him responding to the shortage. But he never addressed the “root cause”, to use a popular phrase with the administration. A brief review is worthwhile. The bulk of the formula is distributed through a social safety net program paid by the Federal government and administered by the states. In an attempt to lower prices, the states have implemented a single supplier, and as it turns out a couple of the companies have garnered the bulk of the contracts. That makes it difficult for new entrants or suppliers. This is not on the Biden Administration, but it is an example of how government intervention can distort the economy and have a negative impact on its constituents. Once again, the moral of the story is that government policies aimed at making the consumers better off distort the aggregate supply and result in higher prices and shortages of the commodity in question. Two wrongs do not make a right.
Reducing the Federal Deficit
President Biden argues that reducing the budget deficit will help ease price pressures (Figure 5). Being charitable to the President’s view, we tried to develop a rationale for his conclusion. One is based on the Phillips Curve. It posits a negative relationship between the unemployment rate and the inflation rate. That is as the unemployment rate declines, the inflationary pressures rise. Presumably reducing the budget deficit leads to a reduction in the overall government expenditure and that in turn reduces the economy’s aggregate demand and thus the inflationary pressures.
The President may argue that the current inflation is consistent with the Phillips Curve. We concede the point, but then ask why the Phillips Curve cannot explain the low inflation rate at a time when the unemployment rate was at or near historical lows during the Trump Administration. In contrast, monetarists argue that inflation is too much money chasing too few goods. As we have written before, the excess money supply does explain both episodes, (Figure 4).
Then there is the issue of the causes of the budget deficit reduction. One major component may be the failure of BBB to pass the US senate. Here the credit goes to Senator Manchin. Another component that the President takes credit for is the surge in tax revenues. But is the revenue surge due to his policies? There are two counterarguments. One is that the recovery would have taken place if the administration had simply reopened the economy. The other explanation is that the source of the revenue surge was the Trump tax cuts. If so, why would he want to undo them? The president is doubling down on tax rate increases, regulations and increasing the Federal government’s control of the economy.
Then there is the interesting fact that whatever economic problem we face, the President’s answer is Build Back Better (BBB). He has argued that BBB will solve inflation, the supply chain, restore growth, transition to green energy, produce growth that works for all, etc. BBB is the elixir that will cure all economic ills.
Overall, the President is correct in naming the Fed as the key to fighting inflation, but chasing productive capacity through aggregate demand policies is a fool’s errand. Similarly, the evidence shows that deficits only matter if the Fed monetizes them. Ultimately, the President’s dirigiste agenda will not reduce the deficit and/or produce a higher real GDP growth rate. If President Biden is not careful, he may produce an economy that works for none.