Is the US economy in a death spiral?

In the fight against high inflation, the US central bank is raising interest rates sharply and is now also reducing its balance sheet total. But the Fed’s tightening of monetary policy may be the wrong recipe for dealing with the current problems and may even be counterproductive. That’s the view of two economists in a study presented last Saturday at the Fed symposium in Jackson Hole, of all places, and initially garnering little attention.

The currently high inflation is primarily a consequence of the higher public consumption with which the US government has mitigated the consequences of the corona pandemic, write researchers Francesco Bianchi from Johns Hopkins University and Leonardo Melosi from the Chicago Fed in their research paper. “Recent fiscal interventions in response to the Covid pandemic have (…) accelerated the recovery but also caused an increase in fiscal inflation,” write the authors. “This rise in inflation could not have been averted simply by tightening monetary policy.”

Without a significant reduction in government spending, the Fed is likely to have trouble keeping inflation under control in the future, even if it continues to tighten monetary policy significantly. “When fiscal imbalances are large and fiscal credibility erodes, it may become increasingly difficult for the monetary authority (in this case the Fed) to stabilize inflation around its desired target,” the paper said.

Since the 1980s, US government spending has grown significantly faster than the US economy has grown, and tax revenues have increased. The federal debt is growing rapidly and has more than doubled since the financial crisis alone.

US federal government debt (source: fred.stlouisfed.org)

The debt ratio (government debt to GDP) has risen from just over 30 percent in the early 1980s to over 120 percent.

Is-the-American-economy-in-a-death-spiral Comment-Oliver-Baron-GodmodeTrader.de-2
US Federal Government Debt to GDP (Source: fred.stlouisfed.org)

The study suggests that without a turnaround in public finances, ie a significant reduction in public consumption and a reduction in debt, it is unlikely that high inflation will be brought under control. The Fed’s rate hike course may even worsen the situation because, given the high level of debt at $30.8 trillion at the latest, interest costs for the US government are likely to rise significantly in the medium term, further clouding the fiscal outlook.

Without a significant reduction in public spending, “a vicious circle of rising nominal interest rates, rising inflation, economic stagnation and rising debt threatens,” write Francesco Bianchi and Leonardo Melosi. “Rising interest rates without sufficient fiscal support could lead to fiscal stagflation,” the study’s authors warn. What is needed instead is “a coordinated monetary and fiscal policy that offers a clear path both for the desired rate of inflation and for debt sustainability.”

Conclusion: If the study’s authors are right, the U.S. central bank could be in for a rude awakening. If monetary policy is significantly tightened further, without a noticeable reduction in public consumption, it may throw the economy into recession, but at the same time not change the high inflation. Although the authors are not opposed to the Fed tightening monetary policy, they call for a significant reduction in government spending. This is the only way to break the vicious circle “of rising nominal interest rates, rising inflation, economic stagnation and rising debt”. What the authors do not address, however: In the short to medium term, a fiscal policy emergency brake alongside the ongoing monetary policy emergency brake can probably intensify the economic shock.

Link to the survey: Inflation as a fiscal limit


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