Inflation Will Increase If Government Spending Spree Continues: Study

A shopper is seen past a sign displaying the price per pound of russet potatoes at a supermarket in Montebello, Calif., on Aug. 23, 2022. Frederic J. Brown/AFP via Getty Images

Central banks including the Federal Reserve will fail to curb inflation unless governments start to be responsible for spending, according to a study presented to central bankers at a Jackson Hole conference in Jackson Hole, Wyoming.

The authors of the study, Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed, warned that increasing interest rates would end up in stagnation without adequate constraints on government spending.

“If the monetary tightening is not supported by the expectation of appropriate fiscal adjustments, the deterioration of fiscal imbalances leads to even higher inflation pressure. As a result, a vicious circle of rising nominal interest rates, rising inflation, economic stagnation, and increasing debt would arise,” they wrote in the study (pdf).

If governments are not spending money responsibly, inflation will be driven up by the private sector’s expectations of high inflation while at the same time the economic output is reduced by hawkish monetary policy, they explained.

“The more hawkish monetary policy would have lowered inflation by only 1 percentage point at the cost of reducing output by around 3.4 percentage points,” the authors wrote. “This is a quite large sacrifice ratio.”

Spending Spree Is Back

After a short pause following the wave of COVID-related stimulus spending, government spending is back in the United States.

President Joe Biden signed the Democrat-backed “Inflation Reduction Act” on Aug. 16, which includes around $433 billion in new spending. The Democrats claimed that the bill will reduce the deficit by around $292 billion annually through stricter tax code enforcement.

President Joe Biden signs the Inflation Reduction Act as Democrat lawmakers look on at the White House in Washington, on Aug. 16, 2022. Drew Angerer/Getty Images

The president also announced a massive student loan cancellation plan on Wednesday.

According to the plan, individuals earning less than $125,000 a year or families earning less than $250,000 will be eligible for up to $10,000 in debt cancellation. Pell Grant recipients who meet those income standards will be eligible for relief of up to $20,000.

The White House estimated that it will cost $24 billion a year over the next 10 years. However, the Wharton School of the University of Pennsylvania said the cost will be much higher than what the Biden administration announced.

“We estimate that President Biden’s proposed student loan debt cancellation alone will cost between $469 billion to $519 billion over the 10-year budget window,” the business school said.

Factors Uncontrolled by Federal Reserve

In the last few months, the Federal Reserve has increased the federal fund rate by 225 basis points to 2.5 percent.

Data shows that inflation may have peaked.

According to a Commerce Department report Friday, consumer prices rose 6.3 percent in July from a year earlier after posting an annual increase of 6.8 percent in June.

However, economists and central bankers are worried about other factors beyond the money supply behind inflation.

One main factor is supply chain bottlenecks for some products.

Federal Reserve Chair Jerome Powell admitted at the Jackson Hole retreat that it’s not covered by the monetary policy.

“It is also true, in my view, that the current high inflation in the United States is the product of strong demand and constrained supply, and that the Fed’s tools work principally on aggregate demand,” he said during his opening remarks.

Federal Reserve Board Chairman Jerome Powell speaks during a news conference following a two-day meeting of the Federal Open Market Committee (FOMC) in the District of Washington on July 27, 2022. Elizabeth Frantz/Reuters

Another worrisome factor is the tightening labor market, which is apparently driving up the costs in almost all sectors.

“The labor market is particularly strong, but it is clearly out of balance, with demand for workers substantially exceeding the supply of available workers,” Powell said.