The Federal Reserve Cannot Fix Inflation by Itself

Inflation is now increasing at a 9.1% annual rate.  The Fed is likely to increase short-term interest rates by at least .75% (perhaps as much as 1%) at its July meeting in order to reduce demand by slowing down the economy.  Increasing interest rates is a blunt tool.  It could easily set off a recession and put a lot of people out of work, creating additional misery at a time when wage increases are already lagging behind price increases.

In my last post, I discussed the basic causes of inflation, namely irresponsible deficit spending by Congress over many years as well as the huge amount of quantitative easing carried out by the Fed in recent years.  These actions have enormously increased the amount of money floating around in the economy by many trillions of dollars.  On top of this enormous buildup of federal debt in the system, it was the $5 trillion in Covid relief stimulus funding in 2020 and 2021 which tripped off the current flare-up of inflation.

Of course, the Fed must now take the strong measure of raising interest rates.  But the Fed cannot fix inflation by itself.  It needs help from Congress on fiscal policy.  Here are a few things that Congress can do:

  • Stop digging, i.e. stop making the inflationary environment worse. This includes ending the remaining Covid relief – that is boosting price levels by 0.2 to 0.7 percentage points.  Avoid adding more to the deficit by such measures as a gas tax holiday, student debt cancelation, expanded veteran’s benefits, or new tax cuts.
  • Lower health care costs. Thoughtful healthcare reform, especially for Medicare providers, Medicare Advantage plans, and coverage of prescription drugs can significantly reduce the inflation rate.
  • Reform the tax code to raise more revenue. Tax increases can reduce demand in a distributionally desirable way, putting downward pressure on inflation.  Congress could also limit tax expenditures and subsidies which drive up specific prices in the economy.
  • Limit discretionary spending, reduce consumption-oriented spending, and shrink aid to states. Congress should reimpose discretionary spending caps and reduce spending on various programs from farm subsidies to Social Security benefits for high earners and federal aid sent to cash-flush states and local governments.
  • Promote work, savings, and investments. Congress could reduce barriers to work by eliminating the Social Security earnings test, allowing older workers to collect the Earned Income Tax Credit, and providing vocational training for disabled workers.
  • Lower energy, trade, and procurement costs. The government could reduce tariffs, end regulations that boost shipping costs, and encourage more extraction of fossil fuels.

Conclusion.  As described above, there are lots of things that Congress and the President can do to help the Fed bring inflation under control.  Such help would lessen the pain by speeding up the whole process, thus increasing the chance of achieving a “soft landing” with a shorter and milder recession than would otherwise occur.

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5 thoughts on “The Federal Reserve Cannot Fix Inflation by Itself

  1. There is no reason to believe that health spending can be managed by price manipulation. The institutional co-dependency between the payors and providers of healthcare that is driven by their market-share goals would not allow it. A national, deeply nested, stop-loss protected financial risk agreement involving all current payers and providers of healthcare would be required. The Design Principles for managing a Common Pool Resource (health spending as a portion of our national GDP) as defined and validated by Nobel Prize awardee Professor Elinore Ostrom would be required. Using pre-pandemic data involving the OECD folks, the excess health spending in the US for 2019 was $1 Trillion. The number represents the use of an achievable goal of 13% of GDP (OECD nations) as opposed to 18% (USA). The change could be achieved within 10 years with a plan to steadily limit the annual increase in national health spending to 0.5% less than our annual economic growth.

    Elinor Ostrom, 2010. Beyond Markets and States: Polycentric Governance of Complex Economic Systems, American Economic Review, 100:641-72 [See Page 653] Note: This is her Nobel ceremony lecture. It can also be watched on YouTube.

    • Granted that we spend a trillion dollars too much on healthcare every year, how do we rim back this enormous excess spending? In particular, can the free market achieve these huge savings or will it take a tightly regulated single-payer system to get the job done?

    • Are there any mathematical models which have been constructed for Elinor Ostrom’s theory? If you know of any, let me know. I’m also looking into this on my own.

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