Incompetent Fed Doing Putin’s and the Republicans’ Work to Damage the U.S. Economy and the Democratic Party?
It is a critical time for the American economy and American foreign policy, given Russia’s illegal and unprovoked invasion of Ukraine along with threats of launching nuclear missiles, causing oil and gas prices to soar and thereby pushing up inflation. Yet, the narrow-minded inflation-obsessed Federal Reserve is about to intentionally precipitate a severe recession by tightening monetary policy, thinking that will get inflation down to its arbitrary 2% target. It believes that to be a logical, intelligent trade-off. That belief is gravely mistaken, since a severe recession will cause unemployment and the budget deficits to jump, while not getting at the root causes of inflation, i.e., skyrocketing oil and gas prices due to Russia, along with lingering Covid supply-chain disruptions. Furthermore, by causing a severe stock market panic and fears of a deep recession just weeks before the mid-term elections, the Fed is actually doing the Republican Party’s work to damage the Democratic Party and American democracy. It is also doing Putin’s work to undermine the country’s resolve to help Ukraine regain its occupied territory and win the war against imperialistic Russia, helping pro-Putin Republicans win in the upcoming elections.
Importantly, the Fed is mistaken to focus on year-over-year CPI inflation numbers, instead of on month-over-month CPI numbers. In fact, the most recent month-over-month CPI numbers are the only accurate gauge of current inflation, not year-over-year CPI numbers. Since oil and gas prices have been declining sharply over the past two months, the recent CPI numbers show current inflation at an annual rate below 4%, as opposed to year-over-year CPI numbers of around 8%. So the Fed should not panic and tighten excessively, as though it were in a race against time.
The Fed should realize that tight money is not the antidote for inflation caused by oil and gas disruptions, repeating the mistake made by Paul Volcker’s Fed in the 1980’s. In fact, it is a total myth that Paul Volcker’s tight money in the early 1980’s “slayed the dragon of inflation”. Incredibly, that myth survives to this day, as Fed Chairman Powell and much of Wall Street have recently praised Volcker’s approach to fighting inflation. That myth is the result of bafflingly flawed logic and disregard for the facts. Rigorous logic and attention to the facts lead to the conclusion that just as spiking oil prices worldwide (from $12 a barrel to $42) caused a massive cost-push inflation in the early 1980’s, stabilizing oil prices due to free market forces caused the eventual decline in inflation. In other words, the sharp rise and fall in inflation had all to do with oil prices, and nothing to do with monetary policy. It would be absurd to claim that soaring world oil prices in the late 1970’s and early 1980’s were due to a loose American monetary policy, rather than to a sudden major reduction in OPEC oil production following the arrival of Ayatollah Khomeini in Iran and the subsequent breakout of the Iran-Iraq War.
Similarly, the first energy crisis of 1973 was caused by OPEC’s nationalization of its oil and the consequent price decontrol, leading to world oil prices jumping from $2 a barrel to $12 overnight. Oil being a very important cost factor, the knock-on effects led to a jump in inflation, leading to the new phenomenon of “stagflation”, a combination of inflation and economic decline. It should be obvious that the jump in world oil prices had nothing to do with U.S. monetary policy, and that a restrictive monetary policy response was totally inappropriate and counterproductive. In fact, since the jump in oil prices was not due to increased oil consumption but to sudden price decontrol, the correct policy response would have been to stimulate investment in non-OPEC oil production and in energy efficiency. High interest rates would clearly hinder such investments, making them more expensive to finance and requiring a higher return on investment threshold.
The reason the Federal Reserve and the economics profession failed to properly understand the oil induced inflation and “stagflation” following the 1973–74 and 1979–80 energy crises, is that the elementary distinction between cost-push and demand-pull inflation was forgotten. That distinction was forgotten because historically most inflation had been of the demand-pull variety, i.e., due to a booming economy with excess aggregate demand. Clearly, a tighter monetary policy is logical when there is demand-pull inflation, but it is nonsensical and counterproductive when there is cost-push inflation. The proper policy response to cost-push inflation is to address the reasons why costs are rising, not to reduce consumer demand and cause a recession.
Today’s global inflation spike is of the “cost-push” variety. It is clearly not due to a jump in American consumer demand, but to global supply-chain disruptions due to the Covid pandemic, subsequently aggravated by Russia’s invasion of Ukraine and the consequent reduction of Russian oil and gas supplies in the West for political reasons. The statistical correlation is perfect. Just as American monetary policy has not been the cause of our domestic inflation, it cannot be the solution. Tightening monetary policy will do nothing to resolve global supply-chain disruptions or spiking oil prices; it will only serve to significantly slow economic growth, increase unemployment and our budget deficits, and give us our third bout of “stagflation”.
It is important to understand that Volcker’s tight money had very deleterious effects, apart from doing nothing to reduce inflation. Not only did high interest rates slow investments in domestic oil production and energy efficiency/conservation, they served to explode American public and private indebtedness. Our budget deficits soared not only for cyclical reasons (lower tax revenues and higher social outlays) due to the recession worsened by tight money. They also soared as federal interest expense skyrocketed: maturing Treasury debt with 7% coupons was rolled over into new Treasury debt with 16% coupons, piling on to newly issued Treasury bonds with historically high coupons. Thanks to a misguided Volcker, the fed funds rate reached 21% in 1983–84, while inflation was below 10%, meaning that the real overnight interest rate (with no future inflation risk!) was an absurd 10%+. Not only did those absurdly high nominal and real interest rates cause our public and private debt to surge, they caused the dollar exchange rate to double, leading to record trade deficits and high unemployment.
Unfortunately, Fed Chairman Powell has now embraced a Volcker-like response to the current cost-push inflation, and he will needlessly cause a recession. He is sharply hiking the fed funds rate and reducing the Fed balance sheet (quantitative tightening), both measures being totally inappropriate.
Apart from finally understanding the difference between the two varieties of inflation requiring different policy responses, Americans must also understand the real causes of our large, record federal indebtedness. One major cause is totally avoidable recessions caused by excessively tight monetary policy and high interest rates, leading to a big cyclical drop in tax revenues and a big cyclical increase in social expenditures. Eliminate all our recessions engineered by the Fed with high interest rates since 1974, and the outstanding federal debt shrinks to very low levels. The other major cause is the very low level of education of many citizens, leading to low average productivity, low incomes, low tax revenues, acute social problems, and high social expenditures. The fault is of our many very mediocre public schools with their deficient curriculums. Scandalously, not one politician is clamoring for a major upgrade, not one would even know how to implement one. Not one realizes, despite widespread addiction and violence, that we need 4-year psychology courses in every high school along with group therapy and good parenting workshops. Not one realizes we need strict class discipline, lots of homework/study-hall, school uniforms, and individual attention for students having academic and psychological difficulties.
© Edward Sonnino 2022
October 7, 2022