Inflation continues to alarm us — controlling it requires fiscal responsibility
According to the Bureau of Labor Statistics, the Consumer Price Index rose 8.5 percent for the 12 months ending in March. This should not have been a surprise — at least not to anyone who understands economics. One only needed to notice the enormous increase in government deficit spending to fund economic stimulus that was financed by an equally massive increase in the money supply via quantitative easing beginning in March 2020. And even though the government has stopped providing economic stimulus, we cannot count on inflation now stabilizing around the Federal Reserve’s stated 2 percent target.
This is because of the connection between deficit spending and Federal Reserve monetary policy. Projections show that although government deficits will be much less going forward than in 2020 and 2021, they are still expected to exceed $1 trillion per year and grow from there. These deficits may be larger than the government can pay back without continuing to substantially inflate the money supply. If Congress does not take steps to reduce government deficits, there is a good chance that price inflation will continue to exceed 2 percent, not just in 2022 but for years to come.
The size of the deficit is important because that will influence how the government finances it. Individuals and businesses wishing to borrow money must convince lenders that they will pay back the principal and interest when it is due. This, of course, places a limit on how much they can borrow. Those who lend money to the government also expect to be paid back. But unlike private borrowers, the federal government’s ability to borrow is essentially unlimited, because it can finance its debt with money created by the Fed.
It’s no secret that Federal Reserve money creation causes price inflation. Nor is it a secret that inflation is a tax on anyone who holds money — but policymakers are all too willing to levy it. If your savings is in a money market account that pays no interest and the inflation rate is 8 percent, you are paying an 8 percent annual tax on it.
Even though part of its mandate is to control inflation, the Fed also faces political pressure to keep the Treasury’s borrowing costs low. The Congressional Budget Office projects that interest on the debt will cost $500 billion in 2022 and rise to $1.1 trillion by 2031, but this assumes that interest rates in 2022 will average 1.9 percent for 10-year treasury bonds and 0.1 percent for three-month Treasury bills. Both are higher than that now, and Treasury bill interest rates are expected to rise substantially over the rest of the year as the Fed seeks to bring inflation under control.
What makes it so difficult to keep interest costs of the federal debt from rising? Controlling inflation will necessitate increasing interest rates in the short run, but higher inflation will also tend to push interest rates up to compensate lenders. If the Fed does not raise rates on reserves fast enough to bring inflation down, market interest rates may rise as investors come to expect those high rates of inflation to drag on.
Prior to 2020, foreign investors, including foreign governments, lent enough to the U.S. government so that, combined with borrowing from domestic investors, it has been able to finance its deficits in most years without much money creation. But in 2021, foreign investors and governments financed about $534 billion of more than $2 trillion of U.S. government deficit spending.
There is no reason to expect foreign investors to lend the U.S. government much more than this in the future, and they could lend less. To the extent that future deficit spending exceeds the amount provided by foreign lenders, it must be financed by some combination of lending from domestic investors and money creation.
To fund deficits greater than $1 trillion every year without money creation requires investors to lend the government an enormous amount of money. Their willingness to do so depends on whether interest rates are high enough. Yet high interest costs would also increase the deficit. To keep the interest cost from getting too high, the Fed may face pressure to expand the money supply enough to cause continued high rates of inflation.
These are among the reasons we find ourselves in a tricky situation of our government’s own making. To ensure that the Federal Reserve can keep inflation under control without pressure to monetize future deficits, Congress should take steps to reduce the deficit so it can be funded mostly by private borrowing. Although tax increases could contribute to deficit reduction, we’re already paying the inflation tax. Limiting spending would work better.
Tracy C. Miller is a senior policy research editor with the Mercatus Center at George Mason University.
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