Inflation has fallen from the shocking highs that were reached last year, but the Federal Reserve's efforts have not successfully returned the beast to its cage.
If rising prices are to be fully tamed, it increasingly looks like Congress will have to get the deficit under control first.
Prices are up 3.7 percent over the past year, according to new inflation data released by the Bureau of Labor Statistics on Thursday morning. But so-called "core inflation," which filters out the more volatile categories like food and fuel prices, rang in at 4.1 percent in the newest report. Some smaller categories have seen considerably faster price hikes over the past 12 months—shelter prices, which include rents and hotel costs, are up 7.2 percent.
In an attempt to control inflation, the Federal Reserve had raised interest rates at 11 consecutive meetings starting in March of last year. Since July, the central bank has left interest rates unchanged—the Fed's current base rate is 5.5 percent, up from 3.25 percent a year ago. Higher interest rates seem to have brought inflation down, but prices are still rising nearly twice as fast as the Federal Reserve's target of 2 percent annually.
It's possible that we've reached the limit of what the Federal Reserve can accomplish in terms of taming inflation through monetary policy. The federal government's $33 trillion national debt and rising budget deficits are creating inflationary pressure in ways that remain underappreciated.
The big problem is that, while higher interest rates are helping curb inflation, they are worsening the federal government's deficit. Writing at CNBC, Kelly Evans gets at the heart of this conundrum: "If we don't quickly close the gap between spending and revenues, the debt load will keep growing, and interest costs will keep on rising, and the deficit will thus stay elevated, which grows the debt load even more."
So what does that have to do with inflation? As Reason contributor Veronique de Rugy, an economist at George Mason University, explains at National Review, there is an assumption built into monetary theory that says fiscal contraction—that is, smaller deficits—will necessarily follow a monetary contraction like the rising interest rates of the past year.
In other words, when central banks make it more expensive to borrow, they assume the politicians in charge of fiscal policy will respond by borrowing less. But that hasn't happened, and there is little indication that it will in the near future. The federal budget deficit nearly doubled in the fiscal year that ended on September 30, and bigger deficits are expected in the next few years—in significant part because of the feedback loop between higher interest rates and rising debt costs.
To fully get inflation under control, de Rugy says the country must experience a period of negative wealth effects—that is, a decline in demand driven by consumers choosing to rein in spending due to declining wealth.
That's hardly something worth cheering for, but it might be the only way to truly tame inflation—and it probably won't happen until Congress curbs spending too.
"The only way to get a reduction of total demand, which will ultimately rein in inflation, is for the fiscal authority to implement fiscal consolidation, hence creating a negative wealth effect," writes de Rugy. "Absent that fiscal contraction, inflation will rise."
Changes to monetary policy have brought inflation down from last year's near-record highs, but the monetary theory upon which that policy is built assumes that fiscal policy will finish the job by reducing deficits. Congress, so far, doesn't seem interested in cooperating—so expect prices to keep rising at an annoyingly fast rate.
The post Inflation Won't Go Away Until Congress Gets the Deficit Under Control appeared first on Reason.com.
