By far the biggest problem in our country right now is inflation, which reached an annual rate of 9.3% in June and is now at 8.2%. I have been devoting a lot of time with this blog in discussing various aspects of this problem, see here, here, and here.
Let’s summarize the fundamentals of inflation, and how to fix it, as explained by the economist John Cochrane in the Wall Street Journal. They are:
- Loose Fiscal Policy is the proximate cause of inflation, i.e. the most immediate cause. The government spent $5 trillion on Covid relief stimulus during 2020 and 2021 and thereby created huge spending deficits in those years (see chart). These huge deficits created far more demand in the economy than could be quickly met and so prices started to increase.
- The Federal Reserve has only a blunt tool to reduce inflation, namely raising interest rates to slow down the economy which, of course, risks causing a recession. So far, the Fed has raised short-term interest rates by 3% and will almost certainly continue raising rates for many months to come, to get inflation back down to the desired rate of 2%.
- Interest Payments on our enormous $30 trillion accumulated debt have already started to increase rapidly because of the higher interest rates. This will, of course, make our already high annual deficits just that much worse.
- The Federal Government will be tempted to spend even more money to help people pay their bills during the recession which may have already started. This will, of course, just make deficit spending that much worse.
- Economic Growth is required for a favorable long-term outcome. This is what happened in the 1980s after the inflation of the 1970s. Economic growth increases taxable income, and therefore taxes collected, which can be used to shrink annual deficit spending. Along with economic growth is needed spending restraint, especially in the form of entitlement reform.
- The Good News is that our inflation problem can be solved by fiscal (congressional), monetary (Federal Reserve), and regulatory (Presidential) policy working together, if these three branches of government are committed to working together.
Conclusion. We are now faced with a very serious inflation problem. It can only be solved by the Federal Reserve, Congress, and the President working together, as described above. We can be confident that the Fed will do its part. Are President Biden and Congress up to doing their own parts? Only time will tell if we come out of our current predicament in a relatively comfortable way (with only minor economic pain), or whether we have new, and much worse, fiscal and debt crises to deal with along the way.