Michael A. MacDowell: Without policy change, stagflation is inevitable

When President Biden and Federal Reserve President Jeromy Powell sat down in the White House on May 31 to discuss the economy, they emerged with an iteration of the traditional role of the FED, namely, to control inflation and optimize employment.

Both men, lawyers by training, understand the anxiety of Americans over inflation and hoped that their meeting would reassure the public that it was under control. What went unmentioned in releases about the meeting was the real concern among economists and others that rising prices, combined with long-run lackluster growth projections, are the precursors of stagflation.

Stagflation is defined as an economy that is experiencing a simultaneous increase in inflation along with stagnate economic growth. Real Gross Domestic Product in the U.S. decreased at an annual rate of 1.5% in the first quarter of this year. This is a precipitous decline considering growth rate in the last quarter of 2021 was 5.7%. The various stimulus programs put into place at the tail-end of the Trump Administration, and expanded by the Biden Administration, are the prime reason for this fast growth.

Initial economic thinking about the relationship between inflation and poor economic growth was that they are opposites. The thinking was that they could not occur simultaneously because there is a trade-off between inflation and employment. As employment diminished labor and other resources would become less expensive. As a result, the cost of producing goods and services therefore decline, and inflation would diminish. Conversely, when the demand for goods and services increases, underutilized factors or production, such as labor, raw materials, and components like microchips, would be induced to come back into the market thereby stimulating economic growth.

For years traditional economic theory suggested that the government could “even out” these inevitable business cycles through fiscal policy when, in times of slow growth, the government would spend more thereby adding stimulus to the economy and reducing recessionary trends.

Additionally, the Federal Reserve, which operates independently of the government’s fiscal policy, could control both the amount of money and the velocity with which money circulates in the economy. By so doing, the Fed could stabilize prices preventing inflation on the one hand and a stagnate economy on the other. For instance, among the various policy options the Fed has at its disposal is the ability to raise interest rates as it is doing now. This makes the cost of borrowing for both families and businesses higher, thereby retarding spending and reducing inflation.

Walking the tightrope of fiscal policy between too much stimulus and too little spending is not easy because it is subject to the whims of the political process. The Fed can make monetary decisions and follow through quickly. In 2020, when the pandemic caused an almost immediate decline in economic activity, and recession seemed eminent, the Trump Administration introduced programs that pushed more money into the economy. That trend was enhanced significantly by the Biden Administration.

Meanwhile, until recently, the Fed continued its “easy monetary policy” maintaining low interest rates, and the purchase of government bonds and other monetary tools that pumped more money into the economy. It did not take long for inflation to raise its ugly head.

The federal government’s ability to turn on the fiscal policy faucet is easier than turning it off because programs financed by increased government expenditures become entrenched. That is especially true today because many of the new federal spending programs fit so nicely into the policy positions of the current administration. Also, inflation pushes more Americans into higher income-tax brackets thereby increasing tax revenue.

There are, of course, a series of exogenous factors, including the pandemic, and the war in Ukraine, which politicians point to as the reason for our current economic predicament. These certainly have added to the problem. However, “too much money chasing too few goods,” brought about primarily by excessive government expenditures, remains the prime reason for our current dilemma — the highest inflation rate in 40 years and slowing economic growth.

Absent a will on the part of Washington to reduce spending, stagflation is almost inevitable.