Congress must show a greater commitment to tackling deficits and debt if we are to avoid the unwelcome effects of persistently high inflation.
Congress must show a greater commitment to tackling deficits and debt if we are to avoid the unwelcome effects of persistently high inflation.
J uly inflation numbers are out, with the headline Consumer Price Index (CPI) ticking up to 3.2 percent from 3 percent in June. The monthly change in CPI was 0.2 percent, which is consistent with annualized inflation of 2.4 percent.
At the same time, core inflation, which excludes volatile items such as food and energy, remained at 4.7 percent — more than double the Federal Reserve’s 2 percent target.
As the recently released Joint Economic Report highlighted:
Over President Biden’s first two years, home food prices rose by 19 percent, home energy prices rose by 39 percent, shelter prices (such as rents) rose by 12 percent, clothing prices rose by 9 percent, new vehicle prices rose by 18 percent, and gas prices rose by 47 percent.
Many commentators — the same ones who played down the risks of inflation in 2021 — were quick to declare victory over inflation with the release of June headline-CPI data showing inflation had fallen to 3 percent. Yet one month’s data doesn’t tell us very much about the trend or trajectory of inflation in the medium term, especially after accounting for base effects in the price level.
Analyzing smoothed annualized monthly changes in core inflation paints a clearer picture of near- and medium-term inflation trends — and average annualized monthly core inflation between May and July is 3 percent, well above the Fed’s 2 percent target.
Current inflation trends seem to be consistent with the estimates of a Brookings Institution study released last year, which forecasted core inflation to stay between 2.7 percent and 4.2 percent through 2024.
Although the primary responsibility of the Fed is to keep prices low and stable, achieving this objective may necessitate more than just its efforts alone. Sound fiscal discipline could also play a vital role in anchoring inflation expectations.
Persistent and substantial budget deficits, coupled with no intention of repaying the resulting debt, can cause trend inflation to deviate from the long-term target set by the Fed. If these fiscal drivers of inflation are not addressed, and the monetary authority decides to raise interest rates, it may lead to a rise in inflation, economic stagnation, and an increasing debt burden.
As Marc Goldwein noted this week, budget deficits have totaled $2.3 trillion — or 8.6 percent of GDP — over the past twelve months. This is unprecedented at a time of full employment and in the absence of an economic downturn.
To conquer inflation, coordinated monetary and fiscal policies are essential. Both policies should be mutually consistent and provide a clear path toward achieving the desired inflation rate and ensuring debt sustainability.
As John Cochrane points out, from a fiscal perspective, the inflation story isn’t looking so rosy:
The U.S. is running a scandalous $1.5 trillion deficit with unemployment at 3.6% and no temporary crisis justifying such huge borrowing. Unfunded entitlements loom over any plan for sustainable government finances.
Indeed, historically, fiscal consolidation has consistently accompanied success at overcoming inflation. This pattern was observed during periods such as the late 1940s and after the 1980–82 recession.
Unfortunately, it appears that Congress lacks the inclination for fiscal discipline and consolidation. The annual rate of federal spending remains elevated at almost $6.5 trillion. Meanwhile, the Congressional Budget Office forecasts that budget deficits will average more than 6 percent of GDP over the next decade, more than 7 percent over the following decade, and more than 9 percent the decade after that.
Adding to the already-grim situation, the surge in interest rates is set to force Congress to spend a staggering 3 percent of GDP to service the ballooning debt burden by 2024. The implications of this fiscal nightmare have not gone unnoticed, as evidenced by Fitch’s recent decision to downgrade the long-term debt rating of the United States a notch, stripping it of its coveted AAA rating.
Instead of establishing a clear path to debt sustainability to anchor inflation expectations, policy-makers in Congress are projected to drive public-debt levels up to 181 percent of GDP in the next three decades — assuming there are no major recessions, unexpected wars, or global pandemics in that time.
While inflation data may fluctuate monthly, the central focus for fiscal and monetary authorities should remain unwavering: reducing inflation and then stabilizing it at the 2 percent target.
Without the Federal Reserve’s resolute commitment to price stability and Congress’s commitment to fiscal discipline, achieving this goal may prove elusive. And that could result in persistent inflation, economic stagnation, and a slow-creeping debt crisis fueled by rising interest rates.