A Blessing in Disguise - April 3, 2022

It appears that most now agree the Federal Reserve has done too little too late to combat inflation. In fact, Powell alludes so himself now. No matter - they have signaled a new path, and too little too late is still better than nothing at all. 

It’s not entirely his fault either, though, as you have seen me lament often. It is policy madness for one agency to try to slow the economy down through higher interest rates to combat inflation when the executive branch is proposing a stimulus budget with a $1.1 Trillion deficit. We may have been emboldened since the U.S. has run ever-growing deficits every year since the year 2000. 

By definition, a running of a budget deficit is fiscal stimulus that has resulted in an incredibly (too) low 3.6% unemployment rate. And, by definition, raising the federal funds rate is monetary tightening. 

Fiscal stimulus can actually provide inflation relief if done correctly. It must improve infrastructure in a way that reduces long run costs, by rebuilding highways, mass transit, pipelines to prevent flaring of stranded natural gas, and, ESPECIALLY, a redesign of the electric grid for greater efficiency and for a necessary expansion of electric vehicles. 

However, the proposals coming out of the White House and Congress do very little of those sorts of things. Instead, politicians favor putting dollars in people’s (voters’) pockets, which is 1/3rd spent and 2/3rds “invested” in the stock market to magnify asset bubbles. 

The lack of cohesive economic leadership is most frustrating for an economist. My political science daughter explains to me that politics is about forming coalitions that can then foment popular choices. I am sure she is correct, but it may not result in good economics. That’s another story. 

There is a blessing in disguise, though. This current inflation is certainly worsened by the latent aggregate demand from all the income thrown broadly at households for the last couple of years. We then just needed some supply shocks, such as supply chain constraints, and now the Ukraine-related energy shock, for our supply and demand curves to explode. Hence, an inflation that I believe is more long term than most politicians (and some Fed officials) wish to believe, because of the wave of wage push inflation that is already starting to rear its head. 

These increasing wage costs are not keeping up with inflation, which then acts as an inflation tax on everybody who spends. Such a tax is highly regressive because lower income people must spend more of their income to consume, and their wages rarely keep up with inflation. Meanwhile, the stock market tends to rise with inflation as product prices rise, and hence profits. Higher income individuals who consume less and save more are hence much less taxed by the inflation tax. Overall, we all pay to some degree in higher costs for goods and services, and then for higher borrowing costs as the Fed must raise interest rates. 

The higher energy costs will encourage efficiency, though. Most all economists believe we need a carbon tax on all fossil fuels to more effectively transition us toward the backstop technologies of solar, wind, geothermal, hydro, and storage. Part of this carbon tax merely reverses the heavy subsidies that have traditionally been offered to the well-positioned and powerful fossil fuels industry. But, most of it acts both as a deterrent to the generation of more greenhouse gasses, and part of it provides us with the resources to address the problems that global warming creates. 

Canada gets this and is moving its carbon tax toward $200 per metric tonne of carbon dioxide emitted over the decade. That is from a nation that is a fossil fuel exporter, so they know they are cutting off their nose to do the correct thing economically. It is unlikely that any sort of carbon tax could ever navigate Congress though. 

Even without a carbon tax, escalating fossil fuel prices at least move us in the right direction, even if it substantially rewards the industry that is creating much of the problem, and much of the resistance in Congress. 

Time will tell how we navigate what is quickly becoming a pretty deep economic mess. At the same time, we are fighting an economic war in Europe, whose citizens in Germany, for instance, are now contemplating imposing energy quotas. We live in interesting economic times.