The current inflation was sparked by fiscal policy—the government printed or borrowed about $5 trillion, and sent checks to people and businesses. The U.S. has borrowed and spent before without causing inflation. People held the extra debt as a good investment. That this stimulus led to inflation thus reflects a broader loss of faith that the U.S. will repay its debt.
The Federal Reserve’s monetary-policy tools to cure this inflation are blunt. By raising interest rates, the Fed pushes the economy toward recession. It hopes to push just enough to offset the stimulus’s fiscal boost. But monetary brakes and a floored fiscal gas pedal mistreat the economic engine.
Raising interest rates can lower stock and bond prices and raise borrowing costs, cutting into home construction, car purchases and corporate investment. The Fed can interrupt the flow of credit. But higher interest rates don’t do much to discourage people from spending government stimulus checks. At best, the economy is unbalanced. The economy needs investment and housing. Today’s demand is tomorrow’s supply.
Slowing the economy isn’t guaranteed to reduce inflation durably anyway. Even in the 2008 recession, with unemployment above 8%, core inflation fell only from 2.4% in December 2007 to 0.6% in October 2010, and then bounced back to 2.3% in December 2011. At this rate, even temporarily curing 6% May 2022 core inflation would take a dismal recession. In 1970 and 1974, the Fed raised interest rates more promptly and more sharply than now, from 4% to 9% in 1970 and from 3.5% to 13% in 1974. Each rise produced a bruising recession. Each reduced inflation. Each time, inflation roared back.
The Phillips curve, by which the Fed believes slowing economic activity reduces inflation, is ephemeral. Some recessions and rate hikes even feature higher inflation, especially in countries with fiscal problems. The Fed will face fiscal headwinds. The Biden administration and Congress will wish to respond to a recession with more stimulus and another financial bailout, which will only lead to more inflation. A recession without the expected stimulus and bailout will be really severe.
Higher interest rates will directly make deficits worse by adding to the interest costs on the debt. Reducing inflation was hard enough in 1980, when federal debt was under 25% of gross domestic product. Now it is over 100%. Each percentage point interest rates are higher means $250 billion more in inflation-inducing deficit.
Many governments, including the U.S. under the Biden administration, want to address inflation by borrowing and printing even more money to help people pay their bills. That will only make matters worse. A witch hunt for “greed,” “monopoly” and “profiteers” will fail to make a dent in inflation, as it has for centuries. Price controls or political pressure to reduce prices will create long lines and exacerbate supply-chain snafus. Endless dog-ate-my-homework excuses, spin about “Putin’s price hike” and transparently silly ideas such as a gas-tax holiday only convince people that the government has no idea what it’s doing.
Monetary policy alone can’t cure a sustained inflation. The government will also have to fix the underlying fiscal problem. Short-run deficit reduction, temporary measures or accounting gimmicks won’t work. Neither will a bout of growth-killing high-tax “austerity.” The U.S. has to persuade people that over the long haul of several decades it will return to its tradition of running small primary surpluses that gradually repay debts. That outcome requires economic growth, which raises long-run taxable income. Raising tax rates alone is like climbing a sand dune, as each rise hurts income growth. The U.S. also needs spending reform, especially on entitlements. And it needs to break the cycle that each crisis will be met by a river of printed or borrowed money, bailouts for big financial firms and stimulus checks for voters.
The good news is that inflation can end quickly, and without a bruising recession, when there is joint fiscal, monetary and economic reform. The inflation targets New Zealand, Israel, Canada and Sweden adopted in the early 1990s are good examples. They included deep fiscal and economic reforms. The sudden end of German and Austrian hyperinflations in the 1920s, when fiscal problems were resolved, are more dramatic examples. In the U.S., tight money in the early 1980s was quickly followed by tax, spending and regulatory reform. Higher economic growth produced large fiscal surpluses by the end of the 1990s. Without those reforms, the monetary tightening might have failed again. If those reforms had come sooner, disinflation might well have been economically painless.
Mr. Cochrane is a senior fellow at the Hoover Institution and author of “The Fiscal Theory of the Price Level,” forthcoming this fall.
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Appeared in the June 28, 2022, print edition as ‘The Fed Can’t Cure Inflation by Itself.’