Powell Must Choose: Fiscal Restraint or Runaway Inflation

Powell Must Choose: Fiscal Restraint or Runaway Inflation by James L. Caton  for AIER

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Federal Reserve Chair Jerome Powell initiated a program of quantitative easing (QE) in March. QE programs have typically combined monetary expansion with the payment of interest on excess reserves to offset the expansion’s influence on economic activity. But, unlike past QE programs, Powell’s expansion has allowed for an increase in M2 of more than 18 percent.

The aggressive expansion supported price increases after a sharp decline in annualized inflation of 5 percent in March and nearly 10 percent in April. In June, annualized inflation rose above 6 percent, a stark reversal. If this trend continues for a few months, Powell must make a choice. As nominal income returns to trend, owing largely to support from monetary policy, Powell will either have to increase interest rates or else allow inflation to increase. While allowing interest rates to rise might be painful in the short term, allowing inflation to get out of hand could unanchor inflation expectations, leading to irreversible damage.

Bernanke and Yellen never faced such a dilemma. They successfully prevented the expansion of the monetary base from affecting the quantity of money as measured by M1 or M2. Powell’s Fed has initiated a program of direct lending to businesses. It has also supported fiscal expansion that resulted in the disbursement of stimulus checks and expansion of unemployment benefits, much of which has been saved by recipients.

As the recent surge of COVID-19 cases moves past its peak, states will resume reopening. Business activity will return. And, as expectations improve, people will begin spending the funds they are currently holding. If Powell is to prevent inflation from taking off, he will have to assure the market that he will not continue monetary easing that supports low interest rates.

The Choice

In the not-so-distant future – likely before the end of the year – Powell will have to allow interest rates to rise. If he does not, investors will likely interpret the increase in M2 as a lack of concern for inflation. Powell has expressed a commitment to easing and has called for continued fiscal support as a recovery has not quite taken off. Larger debt entailed in fiscal support, however, places the Federal Reserve, the U.S. Treasury, and the economy at large in a precarious position.

The federal government, with support from the Fed in the form of QE, has continued increasing its debt burden. Federal debt now exceeds $26 trillion. By comparison, nominal GDP in 2019 was $21.7 trillion and annualized GDP was $19.4 trillion in the second quarter of 2020.

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