Inflation is proving tougher to curb than Federal Reserve Chairman Powell anticipated, and despite indicators that a recession could be coming, consumers and businesses apparently haven’t gotten the memo.
When U.S. inflation peaked at 9.1% in June 2022, analysts attributed about half of the problem to COVID-19 pandemic-related supply-side bottlenecks — including lockdowns slowing factories in China, clogged ports and semiconductor shortages.
As those bottlenecks clear, inflation remains stubborn because U.S. fiscal and monetary policies are not restrictive enough.
The federal budget deficit — thanks to increased entitlements spending, the Chips and R&D Act, the Inflation Reduction Act, bailouts for union pension systems and war in Ukraine — is estimated by the Congressional Budget Office at $1.41 trillion for fiscal 2023. That’s a huge increase from fiscal 2019, the last pre-pandemic year, when the budget gap was $984 billion.
Overall, the deficit has increased to 5.4% of GDP from 4.6% from before COVID, and is expected to rise to 6.1% by 2025. Those percentage differences may not appear large, but in fact they reflect a lot of additional stimulus.
President Joe Biden promises that his proposed budget, due March 9, will curb deficit spending by $2 trillion over 10 years, but that pales compared to the $21 trillion leap in federal debt held by the public that the CBO projects by 2033.
“ Genuine budget discipline is not possible without entitlements reform. ”
Blame what you like — the Trump tax cuts or Biden’s progressive agenda — but negotiations to raise the national debt ceiling and curb federal spending are degrading into a political farce.
Entitlements represent 64% of federal spending and another 9% is debt service. House Republicans may demand spending cuts to raise the debt ceiling, but they haven’t tabled a budget or plan to trim entitlements.
The president baits Republicans by saying they want to cut Social Security and Medicare. Republicans deny any such intentions, but genuine budget discipline is not possible without entitlements reform.
That requires returning Social Security and Medicare to long-term solvency by raising the retirement and eligibility ages, along with reasonable measures to curb other safety net programs. For example, limiting eligibility for the Child Care Tax Credit and Food Stamp to adults willing to work, the disabled and seniors eligible for Medicare.
Against this backdrop, the Fed has hardly been aggressive. When former Fed Chair Paul Volcker attacked the Great Inflation, the pace of price increases peaked at 14.8% in March 1980, and the Fed subsequently raised the federal funds rate to about 19%.
The Fed so far has raised the effective federal funds rate to little more than half of last June’s peak inflation, and the rates on both 1-
and 10-year Treasurys
are currently about 5% and 4%, respectively. Measured against the most recent CPI reading, real interest rates are negative.
During the first 12 months of the pandemic, the Fed kept the federal funds rate near zero with inflation running at 1.1%. Now the federal funds rate is less than 5% with inflation at 6.4%. That larger gap makes monetary policy appear less restrictive now than when the economy was in a pandemic shutdown.
A lot of media coverage has been devoted to big tech and investment bank layoffs but the former over-hired during the pandemic with the surge in demand for technology services and the latter’s bonus structures creates an accordion effect with the ebbs and flows of dealmaking. Elsewhere in the economy, hiring is robust, job openings exceed the number of unemployed 2-to-1, wages are rising at about 6% annually and households still appear confident to spend.
The Fed puts great stock in consumer expectations. Expected one-year inflation as measured by the average of the Conference Board, New York Fed and University of Michigan surveys is 5%. Inflation expectations as measured by spreads between nominal and inflation-adjusted one-year Treasury rates and consumer surveys have consistently underestimated inflation a year later.
Mortgages tell a tale
Sentiment surveys are nice, but observing marketplace behavior is better. So, let’s look at the mortgage market.
In October, the 30-year mortgage rate peaked at 7.1%, but it fell to 6.2% by mid-January. Home builders reported a surge in buyer interest — mortgage applications for home purchases bounced up. Households won’t see a 6.2% mortgage as burdensome if they expect inflation to keep roaring.
In fairness to the Fed, the CPI is overstating inflation, because rents on new leases have been falling and those filter into the index with a lag.
Later this year, the cost of shelter will drag down inflation readings. However, if the job market continues its robust pace of hiring, rents will begin their ascent again and drag up inflation prints, again with a lag.
Ultimately, the Fed will have to raise rates a lot more to get inflation down to 2% and keep them there.
Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
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