Dr. David Cleeton is chairman of the Department of Economics at Illinois State University.
Welcome to Peoria Magazine’s Econ Corner, a recurring feature in which we pose questions to experts about various economic issues and how they affect our lives and careers here in central Illinois. Our guest for December is Dr. David Cleeton, chairman of the Department of Economics at Illinois State University.
Peoria Magazine (PM): With a general election hovering over the nation’s economy, it was inevitable that the current inflationary period would be politicized. Without wading into partisan politics and addressing instead the differing policy proposals—some examples would be reducing federal government spending, lowering taxes, making cuts in the social safety net (Medicare, Social Security, etc.)—how would those moves likely affect inflation specifically? What are some other potential tradeoffs, both good and bad, of those policy measures?
Dr. Cleeton (DC): It is undeniable that the litany of policy proposals mentioned will have direct and indirect effects on the inflationary environment. It is useful to ask: What is the objective?
Inflation is a measure of the rate of increase in a general price level usually expressed in terms of the Consumer Price Index. Price changes serve an important allocative role, efficiently distributing goods and services to their highest-valued use. This is true of both price increases and decreases as suppliers respond and assign more resources toward more valuable production or away from less valuable endeavors.
Supply and demand changes produce these price signals and either an increase in demand or a decrease in supply will both induce upward price adjustments. However, they have opposite effects in terms of the equilibrium quantity exchanged in the market. These economic principles apply to aggregate supply and demand as well as in particular submarkets.
A cycle of embedding reinforced price increases on the supply, or cost, side of markets can result in systemic inflation where markets for labor and other factors of production produce feedback effects… This can lead to self-fulfilling expectations of continuing and perhaps rising rates of inflation.
The policies mentioned all have direct impacts on aggregate demand but are also targeted at attempting to mitigate the impact of inflation on individual and household budgets, clearly a different objective from the battle against the underlying causes of inflation.
Reducing federal spending and lowering taxes would move aggregate demand in opposite directions while having differential distributive effects. In fact, we know that reducing federal government spending to allow an equal, offsetting reduction in taxes would have a small contractionary effect on aggregate demand. But… those directly impacted by the expenditure cuts are unlikely to be the same parties seeing their tax burdens reduced.
Best to leave the job of fighting inflation to those with the experience and tools to wage the battle most efficiently and effectively. That would be the Federal Reserve, which has the mandate to control inflation while attempting to minimize any necessary tradeoff with employment.
PM: Once the Federal Reserve began to take inflation seriously, it moved very quickly and aggressively to confront it, with mixed success so far. Fed Chairman Jerome Powell has said that “we will keep at it until we are confident the job is done.” Does the Fed risk overdoing it? Conversely, what’s the danger of backing off too early? Please discuss the potential ramifications of both, including what historical precedent exists.
DC: Overdoing it clearly refers to the costs of controlling inflation, primarily measured by slowed economic growth and its related labor market impacts. The risks are directly related to the sources of the price increases.
Prior to the COVID crisis, the Fed was starting a tightening by raising interest rates from the near-zero level and ending its practice of quantitative easing, whereby it had been bloating its balance sheet with the purchase of long-term government bonds in an exercise to directly hold down long-term interest rates. This turnaround was expected to bring an end to the long-lived policy of “easy money” required by the slow recovery from the financial crisis.
While the Fed was in the early stages of this tightening, COVID struck and the fiscal policy response to the rapid but short-lived economic plunge was to run up a huge federal deficit to pump money into the pockets of businesses, state and local governments, and individuals and households. The Fed immediately reversed course to an accommodative monetary policy stance. It is clear that both the fiscal and monetary policy adjustment paths were correct in facing the extremely high level of economic uncertainty.
This demand stimulation tided over employees, small and medium-sized businesses, and state and local governments and provided a significant boost to the balance sheet of households as they built up precautionary savings that they have yet to run down. COVID’s impact on global supply chains did produce some inflationary pressures, which have lingered and portend current and future risks resulting from China’s lockdown policy toward COVID. More recently, the supply-side shocks in the energy and grain markets from the Russian invasion of the Ukraine have produced a second round of inflationary impacts, which are working through the system.
The Fed’s steadfast commitment to progressing with further rounds of interest-rate increases to dampen aggregate demand appears to be necessary to ensure that inflation does not become entrenched at an unacceptable level. It is also important to bring interest rates to a sustainable level… so that the Fed can practice effective stimulative policy when needed in the future. The decade of negative real interest rates resulted in inefficient and wasteful investment incentives both for the private and public sectors.
PM: It is not uncommon to find comparisons being made in various media between today’s inflationary episode and that of 40 years ago, or between Jerome Powell and Paul Volcker, with a recent piece in the New York Times declaring that “2022 is not 1982.” Would you agree or disagree? What lessons might be gleaned from 1982, if any?
DC: I took out my first mortgage in 1981 and signed up for a 30-year fixed rate loan set at 15% per year. Inflation was running near 12% per annum but the salary raise I received at the end of the year was 20%. Yes, inflation was out of control and distortionary, but people learned methods with which to cope, some better than others.
Paul Volcker cut through the politics whereby the executive branch, primarily the Office of the President and the Treasury Department, had for at least a couple of decades unduly influenced Fed policy.* This finally established the Fed as an independent entity with a dual mandate to control inflation without disproportionately impacting the labor market. After Volcker whipped inflation, I refinanced my house with a variable-rate mortgage.
We should not forget that the real solution to promoting a sustainable rate of economic growth in a non-inflationary environment is to invest more in human and physical capital, which will raise economic productivity. That allows growth without upward price pressure. We need a more educated workforce, more research and development, and higher investment levels in private and public capital. Hopefully we will also seek to revive an upward, rather than downward, trend in labor force participation.
*There are two recent, well-written books looking at the practice of monetary policy in a historical context. They are 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19 by former Fed Chairman Ben S. Bernanke, and A Monetary and Fiscal History of the United States, 1961-2021 by former Fed Vice Chairman Alan S. Blinder