The Harmful Effects of High Inflation

As readers of this blog know, I am optimistic about the long-term future of our country,  because of our many fundamental strengths.  But I am also quite concerned about the effects of the high rate of inflation we are now experiencing, which is, first of all, driving up the cost of everyday living.

In the near term, the next few years, inflation is going to cause even more pain for millions of Americans.  Consider:

  • What inflation costs workers.  In 2021 inflation reduced real wage gains by 2.4% (see chart).

  • Mortgage rates surge.  The average mortgage rate is now 6.7%, the highest level since July 2007 (see chart). This adds pressure to the already cooling U.S. housing market.  Many would-be home buyers have given up, while many existing homeowners have become reluctant to sell.

  • Likelihood of recession. According to the economist Larry Summers, there is a very substantial likelihood of a recession over the next two years.  This is suggested by the current inflation rate of 8.3%, along with the current low unemployment rate of 3.7%, and the clearly stated goal of Federal Reserve Chair Jerome Powell to raise interest rates as high as necessary to bring the inflation level back down to the desired 2% level.

  • Interest payments on the national debt.  Rising interest rates are already dramatically increasing interest payments on our public debt of $24 trillion.  They hit $63 billion in August 2022 which computes to $756 billion on an annual basis.  Soon interest payments on the debt will exceed $1 trillion per year from the current level (in Fiscal 2022) of $400 billion per year.  Because of inflation, social security payouts will increase from $1.2 trillion per year to $1.3 trillion.  Federal healthcare costs (Medicare, Medicaid, etc.) which amounted to $915 billion in fiscal 2022, will grow by $163 billion next year.  If we do fall into a serious recession, federal tax revenue will erode.

Conclusion.   Workers falling further and further behind in the cost of living, prospective home buyers unable to afford to buy a house, a serious recession substantially raising the unemployment rate, and finally, huge increases in financing our growing debt coupled with recession-induced shrinking tax revenue, all these events will be very harmful to the economy.  Will this likely combined scenario put us into a “doom loop” of decline or “just” mire us in stagflation, draining growth potential from the national economy?  Either way, the whole process will be painful for tens of millions of Americans.

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Americans Are Too Gloomy about the Future III. The Partisan Divide

One of the themes recently on this blog is that Americans are too gloomy about the future. Yes, we have problems. Inflation is making daily life more expensive.  Political polarization is rampant.  Global warming is real.  China and Russia are trying to gang up on us.  But things are much better than they seem.

I consider myself fortunate to be an American because this is such a great country to live in.
I am amazed by the partisan breakdown of people who agree with me.  Consider:

  • Most Republicans, 91%, think that America is the greatest country in the world, while only 61% of Democrats agree. See the chart below.

  • Furthermore, 85% of Republicans think that if people work hard, they are likely to get ahead, while only 53% of Democrats agree. See the chart below.

  • Far more Democrats than Republicans think that the U.S. is worst or near the bottom in such issues as income inequality, acceptance of migrants and refugees, minority rights, religious tolerance, and LGBTQ rights. See the chart below.

  • These issues which exhibit such a partisan divide are as much cultural as economic in nature. Wokeness refers to the left-wing cultural program which represents the tastes and worldview of an insular class of white progressive elites, who sit to the left of non-white Democrats on social issues such as white supremacy, systemic racism, LGBTQ rights, and self-responsibility.

Conclusion.   It is remarkable how our two political parties differ with respect to the quality of life in America and the role and stature of America in the world.  Republicans are much more optimistic about our country than are Democrats.  Of course, we should all try to be realistic about our problems and how to solve them.  But I would rather have optimists than pessimists in positions of responsibility.

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Americans Are Too Gloomy about the Future II. Things Are Better than They Seem

Americans are too gloomy about the future of our country.  Inflation is appearing to be stubbornly persistent.  The political parties have a difficult time cooperating.  Covid just won’t go away.  Our super-power status is challenged by the rise of China.  Is there any good news?  Well, yes there is.  Consider:

  • Democracy is thriving at home. The two political parties are almost evenly matched in strength at the national level.  There is vigorous competition for the control of both the House and the Senate in the upcoming November 2022 elections.  The two big issues are the rise of inflation and abortion restrictions in some states.  Which issues will weigh most heavily with the voters?  We will soon find out!
  • Democracy is also thriving abroad. Ukraine wants to be free and independent and the Ukrainians are willing to fight and die to resist the Russian invasion.  The whole world is watching as the Ukrainians repel the Russians with the help of military supplies from the U.S. and its allies.  The Russian leader, Vladimir Putin, has become an international pariah.  This strengthens the forces of democracy around the world.
  • China is stumbling.  China’s zero-covid strategy has led to massive lockdowns in cities including Shanghai.  And China has additional huge economic problems resting on Mr. Xi’s pivot to the state by unleashing a crackdown on the property and tech sectors.  If China is foolish enough to invade Taiwan, the U.S. and it’s allies will again come to the rescue of democracy.
  • Global warming. The world temperature has risen 2  Fahrenheit since pre-industrial times and this means more evaporation into the atmosphere and more rainfall around the world.  This is likely the reason for the massive current flooding in Pakistan.  Global warming can be addressed effectively by focusing on de-carbonization rather than de-fossilization.
  • Inflation and debt. The annual inflation rate in the U.S. is now hovering above 8%. The Federal Reserve is serious about raising interest rates as high as necessary to bring inflation back down to the desired level of 2%.  This may cause a recession as well as dramatically increase interest payments on our massive and out-of-control national debt.  There is only one good solution to this problem: fiscal restraint by our national leaders.  This will cause some pain for Americans and require courage from our elected officials to accomplish.
  • Conclusion.  There are always serious and urgent issues in a free and open society like ours.  Right now our biggest problem is the high rate of inflation and the economic pain which will be necessary to bring it back down to a comfortable level.  As we begin to experience this pain more directly, I believe we will begin to take the steps necessary to solve this problem.
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The Precarious Fiscal Position of the U.S.

Our most serious national problem is inflation and several of my recent posts have been devoted to this topic.  I believe that the Federal Reserve is serious about bringing down the rate of inflation to the desired level of 2%.  Getting this done has major implications for our economy.

The only way the Fed can lower inflation is to slow down the economy, perhaps causing a severe recession, by raising short-term interest rates.  But higher interest rates mean much higher interest payments on our enormous national debt.  Consider:

  • National Debt. The national debt held by the public (on which we pay interest) is now about $24 trillion, almost 100% of GDP, as high as it was at the end of WWII (see chart).  And it will likely continue growing rapidly in the years ahead.

  • Federal Spending could soon be dominated by just three different items, healthcare programs, social security, and interest payments on the debt (see chart).

  • Interest Payments on the Debt. Estimated at $400 billion for Fiscal Year 2022 (which ends on September 30), interest payments on the debt are projected to reach $1.2 trillion in 2032, just ten years from now (see chart).

  • 30-Year Debt Projection. From about 8% of total federal revenues in 2022, interest payments on the debt could easily spiral up to 40% of federal revenues by 2052, 30 years from now (see chart).

  • Alternatively, interest payments on the debt, at 1.6% of GDP in 2022, are projected to increase to 7.2% of GDP in 2052, 30 years from now (see chart).

Conclusion.  These projections about how fast interest rates, and thus interest payments on the debt, are likely to grow, are conservative and depend on how aggressive the Federal Reserve is in raising short-term interest rates.  If more persistent inflation requires the Fed to raise interest rates even higher, then interest payments on the debt will grow even faster than projected above.
If nothing is done in the meantime, a severe crisis will likely occur before interest payments on the debt reach $1 trillion per year (projected to occur in just 2030, eight years from now).
In other words, the President and Congress have only a few years to adopt strong fiscal restraints (i.e. dramatically reduce annual deficit spending) before a very serious crisis occurs.  Let’s hope that our national leaders are up to this arduous task!

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The Fed Chair, Jerome Powell, Is Serious about Beating Inflation

“Our responsibility to deliver price stability is unconditional.  We are committed to doing that job”                                                 Jerome Powell. Jackson Hole. August 26, 2022

Last week I wrote that we should be optimistic about the future of our country.  I discussed several major trends that are going in the right direction.  But, of course, we do have one big problem right now which may get worse before it gets better.  I’m talking about price inflation.

What Mr. Powell basically said by implication at Jackson Hole is that “inflation must be beat, and it won’t be pretty.”  The problem is made more difficult because the Fed is fighting several headwinds at the same time.  Consider:

  • Globalization. In the 1990s multinational companies constructed global supply chains focused on driving down costs by finding the cheapest place and workers to produce products.  After the pandemic and the Ukraine war disrupted supply chains, many business leaders adopted new processes to increase reliability even if they cost more, such as by moving production closer to home or buying from multiple suppliers.  In other words, globalization is now on hold (see chart). This means higher prices for many items.

  • Labor markets. The U.S. labor force has roughly 2.5 million fewer workers than since the pandemic began compared with what it would have been if the pre-pandemic trend in workforce participation had continued, and after accounting for the aging of the population (see chart).  This means that labor costs are rising faster than usual.

  • Energy, commodity prices. For various reasons, energy and commodity firms haven’t heavily invested in new production over the past decade, creating risks of more persistent shortages when global demand is growing.  This, of course, also raises prices.
  • Fiscal policy. As I have previously discussed, President Biden’s spending policies, including the so-called Inflation Reduction Act, in the past year alone, have increased deficit spending in the short term.  And this doesn’t take into account the inflationary effects of the student debt forgiveness plan, which will cost roughly $500 billion over a ten-year period, as well as driving up the costs of higher education and loans going forward.

Conclusion.  The $5 trillion Covid stimulus spending tripped off the latest inflationary spiral which has now reached 8.5% as of July 2022.  So far, the Fed has raised short-term interest rates 2.5 percentage points and will have to raise them much higher in order to bring inflation back down to the desired 2% level.  Each 1% sustained increase will increase interest payments on our national debt by over $200 billion per year which will make our annual deficits, currently running at about $1 trillion per year, that much worse.  This is a huge problem that must be urgently addressed.  It can be solved, of course, but it will take a great deal of fiscal responsibility (i.e. cost cutting) to get the job done.  Are we up to this major challenge?

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Americans Should Not Be So Gloomy about the Future

I am optimistic about the future of the United States, as I have explained many times on this blog.  But pessimism is much too prevalent in the media.  A list of current problems: the botched Afghan pullout, urban crime waves, easily foreseen inflation, mayhem at the southern border, a self-generated energy crisis, etc.

But consider:

  • The pandemic is well under control, at least in the U.S.  The latest wave of daily new infections is shrinking (see chart) and the CDC has relaxed its safety guidelines.
  • The Ukrainians are holding their own against the Russian invasion of their country. They want freedom and democracy and are willing to fight and die to achieve it.  The U.S. and its NATO allies are providing Ukraine with weapons and military supplies which are being used effectively by the Ukrainian military forces to slow Russian advances to a standstill.  The whole world sees how the West is helping Ukraine defend itself.  This is a big boost for democracy around the world.
  • American democracy is in good shape.  In fact, democracy is thriving in the U.S.  The 2020 presidential election was a stress test but democracy came through in excellent shape.  Since there were, however, pandemic-related voting irregularities in 2020, red state efforts to tighten up voting procedures for mail-in and absentee voting are simply a common sense approach to maintaining election integrity.
  • Inflation really is, of course, a big problem.  We are already in a mild recession that is likely to get worse if the Federal Reserve continues to act aggressively in raising interest rates in order to bring inflation back down to the desired 2% level.
  • Deficits and Debt. Our rapidly growing national debt, now in the vicinity of $30 trillion, as well as Federal Reserve bond holdings (quantitative easing), in the vicinity of $9 trillion, have become a loaded time bomb of loose fiscal and monetary policy.  The $5 trillion in Covid-related stimulus spending essentially blew the cork out of the (debt) bottle and tripped off our current bout of inflation.  The FED can lower the inflation rate back down to the 2% level by acting aggressively.  But, to keep inflation under control in the future, we must rapidly reduce our annual spending deficits.  Hopefully, our national leaders will now be able to much better appreciate the need for real fiscal responsibility and have the political will to get this job done!

Conclusion.  The U.S. is in good shape in a general sense in spite of several particular problems as mentioned.  Inflation is, however, very urgent and serious and must be dealt with firmly by the Federal Reserve.  Since inflation was tripped off by excessive stimulus spending, Congress and the President will now have to act in a far more fiscally responsible manner to keep inflation under control.

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Does the Biden Agenda Really Help Reduce Inflation?

The United States has serious problems to address at the present time such as the Ukraine War and Climate Change.  But, as I have recently discussed, the most serious and urgent problem of all is inflation.

Our enormous national debt of $30 trillion, plus the trillions of dollars in bond holdings by the Federal Reserve (Quantitative Easing) have created far too many trillions of dollars sloshing around in the U.S. monetary system.  It is not surprising that another $5 trillion in Covid stimulus spending in 2020 and 2021, especially the last $1.9 trillion after Joe Biden became president, has now tripped off a sharp increase in inflation.

The current issue of Barron’s warns that inflation is worse than it looks and harder to solve.  This is because of three shortages: labor, energy, and trust in government which have resulted in structurally higher inflation than most people realize. The U.S. workforce has shrunk 12% since the beginning of the pandemic and the transition to green energy means consuming more resources for similar output.  Furthermore, inflation is inversely proportional to the level of public trust held by a country’s citizens, with trust in institutions scarce in high-inflation countries.

The Biden Administration’s Inflation Reduction Act (IRA) purports to address inflation by reducing the deficit by $300 billion over ten years.  But, as pointed out by the Concord Coalition, the deficit reduction is back-end loaded and so may never actually occur.

But more generally, as pointed out by Greg IP in the Wall Street Journal, the IRA is only one of several major pieces of legislation signed by Mr. Biden in the past year.  For example, he signed a bill that vastly expands benefits to veterans exposed to toxic burn pits which adds an estimated $278 billion to deficits over the coming decade.  The infrastructure law from late last year adds $257 billion over a decade and the semiconductor manufacturing and scientific research law adds $79 billion.  This all adds up to a net increase in the deficit by $300 billion, not a $300 billion deficit decrease.

Mr. Biden is thus clearly not giving priority to deficit reduction. His priorities are expanding the social safety net, narrowing social and racial inequities, and combatting climate change.

The deficit reduction in the IRA (see chart) mostly takes place from 2027 – 2031.  But the time to help the Federal Reserve is now, with inflation running above 8%.  The immediate spending on the Internal Revenue Service and healthcare subsidies increases the deficit in the short term.  Again, incentives to invest in green energy, domestic semiconductor manufacturing, and public infrastructure only boost the economy’s supply side in the long run.  In the short term, such investment adds to demand.

Conclusion.  Helping veterans, lowering the cost of healthcare, and encouraging domestic semiconductor manufacturing are worthy goals but they increase deficits, and therefore inflation, in the short run.  The Federal Reserve will have a difficult time reducing inflation on its own. It needs help now!  The Biden Administration should be putting far more emphasis on immediate deficit reduction.

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The U.S. Greatly Needs a Sustainable Climate Policy

I have discussed global warming on this blog many times, most recently here.  Global warming is real and serious but it is not an emergency.  We know that the temperature has risen by 2 Fahrenheit since preindustrial times.  Arctic sea ice is receding.  The ocean is rising at the rate of one foot per century.  Miami could, theoretically, be flooded in a hundred years, but it has lots of time to adapt to rising sea levels.

The greatest threat to the decarbonization of energy sources comes from unsustainable energy policies, especially those proposed by the current U.S. administration.  America’s announced climate goals seek a transition to 100% clean electricity by 2035 and net-zero carbon emissions by 2050.  Such aggressive timelines are at odds with three hard realities: economic, geostrategic, and political.

  • According to the federal Energy Information Administration, global demand for energy will rise nearly 50% by 2050, with fossil fuels still accounting for roughly 75% of the world supply.  A McKinsey & Co. report shows that achieving net-zero carbon emissions globally by 2050 would require $6 trillion in new spending every year for the next 30 years, clearly a practical impossibility.
  • It is increasingly clear that both Russia and China view aggressive Western climate commitments as an opportunity to increase their power and influence.  We have already witnessed what Europe’s reliance on Russian natural gas has wrought: unacceptable dependence on one of the world’s vilest governments.  Meanwhile, China continues to increase its use of fossil fuels as it tries to catch up to and surpass the U.S. as the world’s largest economy.
  • Without committed action by the Group of Seven nations – the U.S., Canada, France, Germany, Italy, Japan, and the U.K. – there is little hope for real climate progress in the coming decades.  And these are the world’s leading democracies, accountable to their public.  The voters in these countries could easily rebel against energy policies that ramp up energy prices, hinder economic growth, and even lead to rationing and blackouts.  According to a July NYT/Siena College poll, only 1% of U.S. registered voters rank climate change as the country’s most important issue, far behind inflation and the economy.

The U.S., which sits atop massive natural gas reserves and has the world’s most innovative economy, is perfectly positioned to lead a realistic green transition.  The administration should announce that U.S. natural gas will become the world’s vital bridge to an eventual carbon-free future.  The U.S. should also strongly support research in carbon capture and storage, the development of lightweight, high-capacity lithium batteries, and next-generation nuclear reactors.

Conclusion.  A transition to clean energy will be more effective and happen more quickly if it is based on sustainable policies and makes full use of America’s vast resources and well-known capacity for innovation.

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What Is Our Most Urgent Problem at the Present Time?

The United States, and the rest of the world, are facing three major problems at the present time: the War in Ukraine, Global Warming, and Inflation.  I have written about all of these problems separately in the recent past, see here, here, and here.

These three problems are, in fact, highly interrelated.  Consider:

  • The Ukraine War. Ukraine wants to be free and independent.  Russia invaded Ukraine to keep it in its own orbit.  The brave Ukrainians are willing to fight and die to expel the Russian forces.  The U.S. and its European allies are helping Ukraine defend itself by supplying military armaments.  This should be continued as long as Ukraine is willing to resist.   But Europe is dependent on Russian gas and Russia is now threatening to cut off gas exports to Europe. This puts huge pressure on Europe to find alternative sources of energy.
  • Global Warming. Global warming is real and serious.  But we need to keep things in perspective.  Yes, the average world temperature has risen 2 degrees Fahrenheit since pre-industrial times.  Although half a million people die each year from heat, 4.5 million perish each year from cold.  Cheap and reliable energy is needed to afford air conditioning in the summer and heat in the winter.
    Rising fuel prices are also making food more expensive.  Low-cost synthetic fertilizer, made from natural gas, is one of the greatest technologies mankind has invented for feeding the world.
    The world gets almost 80% of its energy from fossil fuels.  Instead of sending energy prices sky-high by trying to force a premature transition to renewables, we should focus on funding research to decarbonize traditional energy sources, such as carbon capture and storage, that are affordable and reliable.

  • The annual inflation rate has now reached 9.1% and the Federal Reserve has just raised interest rates again by .75 percent, for a total increase this year of 2.25%, not nearly as much as the 7% increase in inflation during the past year.  Such a modest plan for fighting inflation is based on the optimistic outlook that Pandemic- related supply problems will quickly resolve themselves.
    But focusing on supply issues only does not take into account the enormous buildup in national debt as well as Fed bond holdings (quantitative easing) in the past decade.  This has created an enormous amount of money sloshing around in the economy which has caused way too much artificial stimulation.
    A more aggressive Federal Reserve, aided with fiscal restraint by Congress, will get our inflation rate back down to a reasonable level more quickly and with less pain in the long run.

Conclusion.  The U.S. is handling the Ukraine War as well as it can.  But the war is putting Europe in a bind because Russia is threatening its energy supplies.  Trying to make a transition to clean energy too quickly is causing a lot of unnecessary pain and suffering around the world.  On the other hand, inflation is a more urgent problem than is recognized by our national leaders.  The Federal Reserve and Congress should be taking it much more seriously than they have so far.

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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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