Category: Economics

Two weeks ago: Could our epic deficits drive inflation no matter how high the Fed raises rates?

John H. Cochrane, the superstar economist (and sailplane pilot! How does that work when you’re a professor at University of Chicago and the nearest ridge is 1,000 miles away?), answers the question in the Wall Street Journal… “The Federal Reserve Can’t Cure Inflation by Itself”:

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.

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.

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.

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.

In other words, as long as Congress keeps borrowing and spending, at least according to Professor Cochrane, we can experience inflation even with high interest rates from the wizards behind the curtain at the Fed. Maybe there could be a house price crash due to the high interest rates (how many people can afford a $20,000 per month mortgage on a 4BR?), but that won’t bring down the headline inflation number since house prices were taking out of the government’s official stats. The rent prices that are in the CPI stat shouldn’t come down because mortgage rates are high. In fact, maybe the high mortgage rates will lead to higher rents since renting is an alternative to buying and paying a mortgage.

On the third hand, though our realtor says that the crash hasn’t happened yet here in South Florida, houses are sitting longer on the market. This could be because it is mid-summer and that is the traditional dead season for real estate. Here’s a fairly standard 5BR house on a busy street in Abacoa:

Note the 38 days on the market at the bottom. In January 2022, this place would have sold within two weeks. Zillow estimates the payment for living on this vast 1/4-acre estate and listening to cars zip by all day at $17,576 per month. For that to be one third of a buyer’s income, he/she/ze/they would have to earn $633,000 per year (i.e., be a dermatologist or plastic surgeon).

Related:

• Cochrane’s calculation of the complete tax rate for a successful Californian (he also has a job next to Stanford): How much is the property tax? In Calfornia, we pay 1% per year. That doesn’t seem bad, except that property values are very high. You can’t get a tear-down in Palo Alto for under $2 million. If you buy a house that costs 5 times your income — say someone earning $200,000 per year buying a $1 million house — then that is equivalent to 5 percentage points additional income tax. On top of 42% federal, 13.2% state, 9% sales, and other taxes, it’s part of my view that we’re past 70% top marginal rate now.
• “How did Paul Krugman get it so Wrong?” (2009): Most of all, Krugman likes fiscal stimulus. … In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any more effect than spending financed by raising taxes. … If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt. If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up. [Good news for the PPP program is next] If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.

Americans are obsessively following the Federal Reserve’s interest rate adjustments in hopes of figuring out if the future will be inflation, recession, or some combination (stagflation). “Fed likely to boost interest rates by three-quarters of a point this week” (CNBC) is an example.

What if nobody other than the government borrowed money for any reason and, therefore, the Fed’s interest rate became irrelevant to ordinary subjects. Could we still have inflation? Two economists say “yes” in “The Real Cause Of Inflation Is Insane Deficit Spending” (February 2022):

But proponents of MMT do get one thing correct — the Fed can create money to service the debt and avoid a default. But in real terms, meaning adjusting for inflation, this assertion is false. Creating money to service the debt devalues the currency. Investors then receive a lower real return on their holdings of federal debt.

(see also this 1983 paper from the Minneapolis Fed)

In the old days, inflation came down when the Fed raised rates. Therefore, unless our deficits are larger than in the old days, the interest rate hikes should work to tame inflation (maybe by damaging the economy). “U.S. deficit will shrink to $1T this year before soaring, federal forecasters say” (Politico):

While the nation’s shortfall has substantially declined following last year’s $2.8 trillion deficit, the Congressional Budget Office estimates the gap between spending and revenue will grow starting in 2024, reaching more than 6 percent of GDP a decade from now. The U.S. has only run greater deficits than that six times since 1946, CBO noted.

We’re actually in uncharted territory when it comes to deficit spending.

Another reason that inflation came down when the Fed raised rates is that people weren’t able to pay as much for houses, nearly always bought with borrowed money. But the current headline inflation rate has been cooked so that it doesn’t include the actual prices paid for houses or mortgages (those 1980s headlines were too alarming under the old formula!). The inflation rate won’t move until the fictitious “owners’ equivalent rent” changes.

Some prices that are part of the price index will obviously fall if the Fed causes a recession with high interest rates. Used cars, perhaps. But, given the huge deficits indulged in by Congress, will high rates and a recession be enough to push headline inflation down to the 2 percent level that the Fed claims to be targeting? Consider that if there is a recession, the welfare state will automatically kick in to increase spending on housing subsidies, taxpayer-funded health care (more people eligible for Medicaid), SNAP/EBT, Obamaphone, and free home broadband. Congress also likely won’t be able to resist massive new spending initiatives to combat the recession, just as they spent massively to combat the economic impact of the coronapanic shutdowns ordered by government.

Update, June 28: Economist answers my question about high interest rates and high deficits

Related:

• “President Biden orders 100-percent federal reimbursement for city’s Covid hotels” (January 22, 2021), in which taxpayers in Louisiana and Mississippi were forced to pay for San Francisco’s generosity in providing 2+ years of hotel rooms for the unhoused. If there is a housing “emergency” declared due to an interest rate rise, presumably the same executive order mechanism could be used to increase the federal deficit by spending on hotels.
• The $12 sandwich here in San Diego is temporarily $14 (up 17%):

• Below, sign at a South Florida car dealer, June 9, 2022

Although quite a few people of modest means enjoy aviation as a hobby, those of us who fly small aircraft often encounter the financially comfortable ($10-100 million in savings; when a house in Palm Beach costs $210 million, a centimillionaire can’t be considered “rich”). U.S. government coronapanic policies made these folks quite a bit wealthier, sometimes doubling their net worth in nominal dollars. At the same time, what they’re able to charge for working hasn’t changed too much and the Trump tax law changes caused their marginal tax rate to go up (state income tax no longer deductible from federal).

All of these people have enough savings to retire, but many continued to work when a year of hard work could increase their net worth by 5 percent. Quite a few of them have said that they’ve scaled back their efforts ever since asset prices took off. A year of hard work will now bump the net worth by only 2 percent and the typical person I’m writing about is in his 50s or early 60s. He might have only 10 more years of reliably good health. Why spend that final decade of vigor at a desk and starting at a computer if it won’t move the wealth needle significantly? These people already own a house, a vacation house, and a reasonably new fleet of vehicles. They don’t have a landlord demanding a 40 percent rent increase. Why not play tennis, kiteboard, hit the golf course, ski every day, or travel?

Does it matter to an economy when more of the most successful people retire younger? If we assume that their financial success can be attributed to luck, then it might be good. More positions will be open at the top of various enterprises, which will motivate people in their 40s to work harder. If, on the other hand, we assume that hard work, skill, and intelligence were primarily responsible for success, the American workforce is losing a lot of its best people.

“Will Inflation Stay High for Decades? One Influential Economist Says Yes” (WSJ):

When the global economy tanked in March 2020, the rate of inflation looked like it was heading to zero. That made it a surprising moment for former U.K. central banker Charles Goodhart to predict that inflation would hit between 5% and 10% in 2021—and stay high.

“The coronavirus pandemic will mark the dividing line between the deflationary forces of the last 30 to 40 years and the resurgent inflation of the next two decades,” said the 85-year-old economist in an interview. He predicted that inflation in advanced economies will settle at 3% to 4% around the end of 2022 and remain at that level for decades, compared with about 1.5% in the decade before the pandemic.

He argued that the low inflation since the 1990s wasn’t so much the result of astute central-bank policies, but rather the addition of hundreds of millions of inexpensive Chinese and Eastern European workers to the globalized economy, a demographic dividend that pushed down wages and the prices of products they exported to rich countries. Together with new female workers and the large baby-boomer generation, the labor force supplying advanced economies more than doubled between 1991 and 2018.

Now, he said, the working-age population has started shrinking across advanced economies for the first time since World War II, and birthrates have declined as well. China’s working-age population is expected to shrink by almost one-fifth over the next 30 years.

The beauty of the above theory is that we can mark our calendars to test it! I propose January 15, 2028. At least currently, the BLS releases CPI numbers on January 12. The economy is subject to heavy manipulation by politicians seeking reelection, but 2027 won’t have been an election year.

How about we say that this guy is a genius if inflation has, in fact, run at an average rate of higher than 3 percent for the period January 2021 through December 2027? I don’t think it is fair to demand that he be held to the 4 percent upper bound due to the fact that desperation and incompetence among politicians could easily result in some months or years of runaway inflation. I’m going to schedule a blog post for January 15, 2028!

With houses in any reasonably desirable neighborhood going up by 20-50 percent per year, you might argue that betting that Charles Goodhart is correct is too easy. But the WSJ mentions some naysayers.

A central criticism of Mr. Goodhart’s thesis is that countries with more retirees and fewer workers, such as Japan, have the opposite problem—very low inflation rates.

(Wikipedia says that he has a Ph.D. from Harvard and is an professor emeritus at LSE, but he is “Mr. Goodhart” rather than being presented as a colleague of Dr. Jill Biden, MD, PhD.)

I’m prepared to love Professor Dr. Goodhart because he references the Black Death in responding to the above criticism:

Mr. Goodhart argued that workers likely won’t save enough for their retirement, and that pensioners consume more than they produce, especially with healthcare. The dwindling pool of savings, combined with increased corporate spending to secure supply chains and make up for a lack of workers, will push up interest rates, he predicted. He said the Black Death, a 14th century pandemic, triggered a quarter-century of soaring wages and rampant inflation.

See

• Immigration is the Reverse Black Death?
• Movie suggestion: Black Death
• Black Death lesson: immigration will discourage women from working
• Lessons from the Black Death regarding coronavirus
• Academic lectures on a modern subject: the Black Death

for my own Black Death obsession.

If Goodhart is correct, anyone who doesn’t take a fixed-rate 30-year mortgage offered at 3.25 percent is going to feel stupid!

Raging inflation at the sushi and noodles place near Legoland (burned some $4.50/gallon dinosaur blood in the minivan):

Can we find someone to blame for our debased money? The Wall Street Journal can! “The Humbling of the Federal Reserve” (3/14/2022):

The central bank faces an inflation mess of its own making.

Government spending excesses in 2020 and 2021 played a role, but the Fed made all of that easier to pass by maintaining the policies it imposed at the height of the pandemic recession for two more years. Low interest rates make deficits seem more fiscally manageable than they really are. The Fed has continued to buy Treasurys and mortgage-backed securities even as inflation nears 8%—right up until this week’s meeting.

What went wrong? The Fed is supposed to have the world’s smartest economists and access to the best financial information. How could they make the greatest monetary policy mistake since the 1970s?

Part of the answer lies with the Fed’s economic models, which are rooted in Keynesian analysis in which demand trumps all. The Fed models give little thought to incentives for or barriers to the supply-side. As finance scholar Emre Kuvvet wrote recently on these pages, among economists in the Federal Reserve System, Democrats outnumbered Republicans by 10.4 to 1 in 2021. They prefer James Tobin over Milton Friedman.

This leads the Fed to overestimate the growth effect of federal spending but underestimate the growth benefits of regulatory and tax reform. For years after the 2008-2009 recession, the Fed’s governors and regional bank presidents predicted faster GDP growth than what happened. But they missed the faster growth after the 2017 tax reform.

What happens next? We’re told to expect an 0.25 percent increases in interest rates. How much of a difference can that make when interest rates remain lower than inflation (i.e., when you’d have to be a fool not to borrow)?

The news from Legoland isn’t all bad, incidentally. There are no problems too challenging for Presidents Biden and Harris to tackle from the White House:

History lesson: a stroller was often as important as a battle axe:

Related:

• “Disney C.E.O. Says Company Is ‘Opposed’ to Florida’s ‘Don’t Say Gay’ Bill” (NYT) (but Legoland’s CEO has not taken a position on 2SLGBTQQIA+ education for kindergarteners)