Kevin Wolf/AP Photo
Federal Reserve Chairman Jerome Powell testifies before the House Financial Services Committee, June 23, 2022, in Washington.
At its last policy meeting, the Federal Reserve Open Market Committee voted to raise its benchmark interest rate by 0.75 percent—the largest single hike since 1994. Expectations are for a similar-sized hike in July.
The reason, of course, is the highest rate of inflation in four decades. Fed chair Jerome Powell is under intense pressure from the business class and both political parties to do something about the problem, and so he is.
But there are strong indications that, at a minimum, he is hiking far too quickly, and in the process running a large risk of tipping the economy back into the same pit of stagnation it was stuck in for a decade after the Great Recession. This is especially true because the federal government is already through fiscal policy doing the job that the Fed is attempting: slowing down the economy to crush demand. Amplifying it with rapid interest rate spikes guarantees a deeper recession.
A substantial chunk of the inflation problem is being caused by supply disruptions that the Fed cannot fix—pandemic disruptions in China, ongoing problems caused by decades of weak investment, and above all Russia’s war on Ukraine. Indeed, as economist J.W. Mason points out at Barron’s, Powell himself admitted as much at a recent press conference: “In effect, we’re looking at a job that calls for a sewing machine, or maybe a fire extinguisher, when all Powell has is a hammer. But as the rest of the press conference made clear, he plans to go on swinging it.” Since then, other economists within the Fed itself (at its San Francisco branch) recently concluded that spending can account for only about a third of inflation.
Moreover, as my colleague David Dayen points out, the Fed’s hiking will likely worsen the supply situation over the medium term, by making investment much more expensive and much less likely to pan out in terms of future sales and profits. For instance, while soaring rents are a big part of the inflation problem, new housing starts are plummeting thanks to skyrocketing mortgage rates.
But the fiscal dimension to the economy has thus far gone largely unnoticed. Inflation-phobes like Larry Summers blame rising prices on the large fiscal stimulus from the pandemic relief packages. That was likely responsible, as noted, for a portion of the inflation rise. But what they tend not to mention is that since that time—the American Rescue Plan was passed 15 months ago—the balance of taxing and spending has turned heavily negative.
As Nasiha Salwati and Louise Sheiner point out at Brookings, “Fiscal policy reduced U.S. GDP growth by 3.5 percentage points at an annual rate in the first quarter of 2022.” That’s projected to hit a top economic drag of 4.1 percent in the second quarter of this year—or almost twice the peak level of austerity after the Great Recession—and then fall slowly. The reasons are the fading out of pandemic measures and an increase in tax receipts thanks to relatively strong growth.
A substantial chunk of the inflation problem is being caused by supply disruptions that the Fed cannot fix.
In other words, the United States is currently undergoing a great deal of austerity. Indeed, President Biden has repeatedly bragged that the government will reduce deficits by about $1.5 trillion this fiscal year.
By itself, this austerity will have negative effects on the economy, including job loss and wage reductions, which is not at all good. But it should also substantially ease the pressure on Powell to hike so quickly. With fiscal policy pressing hard on the economic brakes, there is less reason for him to be doing the same thing, especially because the Fed can’t affect half the reasons inflation is happening except by making them worse. There is also no reason for President Biden to listen to advisers who reportedly want to counter the effects of canceling some student loan debt by restarting remaining student loan payments. Since we’ve had no payments on these loans for over two years, from a current policy baseline this would translate into even more austerity, in the form of a substantial tax hike on approximately 30 million people.
There’s also a looming health insurance price spike coming this fall, as subsidies for Affordable Care Act exchanges expire. When asked whether he was concerned about this severe inflationary action, Senator and Emperor for Life Joe Manchin (D-WV) responded, “you gotta start paying down debt” to fight inflation, and “there’s only so many dollars to go around” to … prevent inflation in health insurance rates. The Fed shouldn’t be aiding and abetting steel-trap logic like this by pushing very hard with its economic lever in the same direction to bring investment, hiring, consumer spending, and economic activity to a halt.
Powell should be doubly careful because, absent some kind of pandemic-sized crisis, it is impossible to imagine another round of serious fiscal stimulus. Swing-vote Senate Democrats are already allergic to the idea, and the party will likely lose one or both chambers of Congress in the midterms. Indeed, it’s easy to imagine a future where there is no fiscal stimulus for a decade or more (except possibly tax cuts for the rich, which is the worst possible kind). If Powell hikes too eagerly, he will tip the economy into recession, and then he will have no fiscal help getting growth started again.
In the days of unquestioned neoliberal hegemony, economists often referenced former Fed Chair William McChesney Martin, who described the Fed’s role as being like a “chaperone who has ordered the punch bowl removed just when the party was really warming up.” Though Martin’s speech was actually fairly nuanced, this slogan came to mean that the Fed should mainly be on hyper-alert for price increases, and start hiking before inflation even got started.
I propose a new party scenario as an intuition pump: The Fed should keep the supply of punch coming at a level that keeps the party rocking as long as possible. It wasn’t the Fed that started the party—that was the pandemic relief, associated supply problems, and Vladimir Putin—but now it’s largely their responsibility to manage. Too much punch and people will get drunk and fall down (inflation), but too little and they will get bored and go home (recession or 2010s-style stagnation).
If Powell keeps a light touch on interest rates, with some luck the party will be rocking hard enough that it will last a good long while. If he’s hasty, then we’re all going home before we can even get a good buzz going.
