Stop Blaming the Fed
Globally, the current inflation levels are reminiscent of those experienced during the 1980s. While moderate inflation is generally regarded as desirable, functioning as an indicator of economic prosperity, the long-run aggregate supply (LRAS) model reveals the direct relationship between supply-demand shifts and inflationary pressures. A burgeoning LRAS during economic development generates an inevitable price rise, leading to inflation. However, the passage of recent stimulus packages in the United States has resulted in a significant decline in the value of the U.S. dollar. The U.S. inflation rate as of March 2023 stands at 6.4%, with a staggering zenith of 9.06% in June 2022 (U.S. Inflation Calculator). These figures cause concern, notably that the average U.S. inflation rate over the past decade has remained low, hovering around 1.88% (Forbes). Given the current state of inflationary pressure in the United States, remedial measures must be implemented to address these challenges.
It is commonly believed that America's inflationary perils are induced by its monetary policy. However, this assertion needs to be revised. The Federal Reserve has steadily increased its interest rates since the start of 2022, with the current rate hovering around 4.75%. This rate is high when analogized to America's historical interest rates. In contrast, in March 2020, the rate hit an unparalleled low of 0%, enabling borrowers to borrow money without incurring interest charges (CountryEconomy, 2022). Theoretically, such a policy should cause rampant inflation. However, empirical evidence suggests otherwise, as explained in greater detail in Option 1 below. Despite the Federal Reserve's interest rates being aggressively low since 2008, inflationary pressures have remained relatively subdued in the past decade, as shown by Diagrams 1 and 2.
Diagram 1 Diagram 2
Source: Bureau of Labor Statistics. Source: Federal Reserve System
Jerome Powell, the chair of the Federal Reserve Board, has recently hiked up interest rates in an attempt to curb inflation in the United States. In the March 2023 Federal Open Market Committee (FOMC) meeting, Powell stated that interest rates would likely be "higher than previously expected" and that the road to control inflation would be "bumpy" (Cox). However, historical data suggests that such an approach harms the U.S. economy more than reasonably. Despite the strict constrictions on the money supply, inflation rates have only decreased by a mere 0.1%, from 6.5% in 2022 to 6.4% in 2023 (U.S. Inflation Calculator). The limitation on economic growth is a significant issue with this strategy. The rise in interest rates had direct consequences, as exemplified by the Silicon Valley Bank crash in March 2023. During the pandemic, people opted to save money in banks rather than borrow. Banks such as Silicon Valley Bank were left with a surplus of funds, which they chose to invest in U.S. treasury securities, a seemingly secure option at the time. However, the rapidly rising interest rates led to a significant decrease in the value of these securities and, as a result, the bank's investments, amounting to around $1.8 billion (Chittenden 2023). This event resulted in the most significant banking crash since 2008, severely impacting America's economic system.
A crucial barometer of economic success, America's housing market has experienced a marked downturn. The Federal Reserve's continuous increase of interest rates has resulted in wild swings in mortgage rates, rendering new houses unaffordable for many first-time buyers. This has brought the housing boom of 2020 and 2021 to a screeching halt, and real estate sales in California alone dropped 44.1%, a dramatic reversal from the nearly 90% sales increase observed earlier this year. The heavy role of real estate in the U.S. economy further compounds the issue. Real estate serves as excellent collateral for borrowers, enabling them to borrow more from banks and invest more. However, the fluctuation in housing prices directly impacts homeowners' credit, as evidenced by a 2018 study by Indraneel from the University of Miami. It found that a single one standard deviation increase in home prices led to a decrease of 21% in total investments. To mitigate this economic slowdown and avoid repeating the 2008 housing bubble burst, the housing market should be a top priority in the upcoming fiscal year.
Diagram 3
Source: CALIFORNIA ASSOCIATION OF REALTORS ®
Compounding the situation, China emerged from its Covid Zero strategy in January 2023 and has regained its global economic dominance. This development further exacerbates the challenges facing the United States, as it risks ceding its hegemonic position to China's resurgent economy. Thus, Chair Powell is confronted with a precarious balancing act in which he must navigate the twin imperatives of inflation control and economic competitiveness.
Who do we blame?
The genesis of the significant inflation that has plagued the U.S. since 2020 is linked to the country's fiscal policy. To understand this, one must first scrutinize the government's measures in response to the COVID-19 crisis. To protect public health and provide assistance to those who lost their jobs due to the pandemic, Congress enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act in 2020, which carried a price tag of a staggering $2.3 trillion, equivalent to an astounding 10% of the GDP (Elis, 2020). But the spending spree continued, with several smaller stimulus payments adding up to approximately $5.2 trillion (Parlapiano, 2022). Adjusting for inflation, the total cost of World War II would amount to just $4.7 trillion. Such a massive injection of new cash into the economy has necessitated the printing of an unprecedented 13 trillion dollars by the Federal Reserve (Surz, 2021), which, in turn, has prompted a decline in the value of the dollar, following the fundamental principles of supply and demand in the monetary market.
America now has two options for fixing the economy:
The U.S. economy faces complex challenges, including high inflation and the possibility of a recession. While policymakers must address these issues, they must also consider global events such as the Silicon Valley Bank crash and the war in Ukraine,
which could further destabilize the economy. Historical data suggests that lowering interest rates may help reduce inflation. At the same time, Congress should limit its expansionary fiscal policy and instead focus on a more passive and long-term stimulus program to prepare for a potential recession. Progressive unemployment insurance could provide a safety net for Americans without causing inflation. Maintaining a balance of expansionary monetary policy, limited fiscal policy, and passive stimulus is crucial for navigating the US economy's current challenges.
Conclusion
Despite government intervention, American households are still grappling with inflation rates as high as 6.4% and exorbitant housing prices, potentially culminating in another housing crisis akin to 2008. Unchecked high inflation rates can be detrimental to an economy, eroding the purchasing power of consumers and weakening the real estate market. The key to mitigating inflationary pressures is judiciously utilizing fiscal policy rather than contracting the money supply to invest in long-term benefits like progressive unemployment insurance. The Federal Reserve has a safety net in the form of record-low unemployment rates and diminishing wages, which should prompt Powell to refrain from contractionary monetary policies. Though it is unlikely that America's inflation predicament will be fully resolved overnight, these measures are vital in the right direction. With China's resurgence on the global stage, it is imperative to spur economic growth and rejuvenate the U.S. economy.
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