How the US can manage inflation – and stem the obliteration of the middle class

Contrary to those advocating austerity, inflation peaked on its own, rather than due to the Fed’s intervention, in mid-2022
Using budget cuts to engineer a recession and tame inflation would adversely affect the middle class. There are ways, however, for policymakers to empower the middle class and disempower bankers

James K. Galbraith

Published: 3:43pm, 10 Aug 2023

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Back in 2021 and early 2022, a posse of prominent economists – including Lawrence H. Summers, Jason Furman and Kenneth Rogoff, all of Harvard University – criticised the Biden administration’s fiscal and investment programme, and pressured the US Federal Reserve to raise interest rates. Their argument was that inflation, fuelled by federal spending, would prove “persistent”, requiring a sustained shift to austerity. Unemployment, sadly, would have to rise to at least 6.5 per cent for several years, according to one study touted by Furman.

While this trio – and many like-minded commentators – failed to sway the White House or Congress, they were in tune with Fed chair Jerome Powell and his colleagues, who began hiking interest rates in early 2022 and have kept at it.

The Fed’s rapid monetary-policy tightening soon prompted progressives, led by Senator Elizabeth Warren, to fear that it will trigger a recession, mass unemployment, and – though they didn’t say it – a Republican victory in 2024.

But the macroeconomic situation today has confounded both positions. Contrary to those advocating austerity, inflation peaked on its own in mid-2022, owing partly to sales from the US Strategic Petroleum Reserve. There was no persistence, no surge from the 2021 fiscal stimulus, and no wage-driven inflation from low unemployment.

There also has been no recession, unemployment has not risen, and higher interest rates have not deterred business investment. A recession remains possible, but so far there are very few warning signs.

These happy circumstances have led some observers to congratulate Powell and the Fed on achieving a “soft landing”. But there is no way that rate hikes beginning early last year could have knocked back inflation by July of the same year. The Fed’s policy tightening has been irrelevant to the inflation slowdown so far.

But why haven’t months of rising interest rates had any perceptible effect on employment, investment or growth?

A driver delivers beverages in the Little Tokyo district of Los Angeles on July 27. The labour market has added jobs at a steady clip in the past year, despite efforts by the Federal Reserve to cool the economy. Photo: AP

Part of the answer lies in new tax incentives for investment, notably in semiconductors and renewable energy. But those sectors are fairly small, and their growth will have accounted for perhaps a 100,000 jobs.

Another part of the answer may lie in direct investment by companies fleeing Europe’s industrial decline, itself a byproduct of sanctions against Russia. But, again, these numbers cannot be very large.

What else is going on? One factor, suggested to me by Robert Aliber, an emeritus professor of economics and international finance at the University of Chicago, is that the top quarter of US households became cash-rich during the pandemic. These households represent the largest share of US purchasing power, and their spending is largely immune to high interest rates.

Another suggestion comes from Warren Mosler – the godfather of modern monetary theory – who notes that US national debt has risen to nearly 130 per cent of gross domestic product, up from about 60 per cent in the early 2000s.

The net interest paid on that debt increased by 35 per cent from 2021 to 2022 – reaching 2 per cent of GDP – and about 70 per cent of those payments went to the US private sector. If one adds the effect of interest paid on US$3 trillion in bank reserves, the fiscal support through this channel has been substantial.

History supports Mosler’s conjecture. Back in 1981, US federal debt was only about 30 per cent of GDP, and much of it was in fixed-interest, long-term bonds, with no interest paid on bank reserves. As a result, then Fed chair Paul Volcker’s large interest-rate increases mostly hit private debtors and business investment, and the offsetting fiscal boost from interest payments was small.

In contrast, when the federal debt exceeded 100 per cent of GDP in 1946, almost all of it was in war bonds held by US households. Despite yielding only 2 per cent in interest, those bonds provided a boost to private incomes and a base for mortgage borrowing through the 1950s – a time of largely stable middle-class prosperity.

The “fiscal channel” for interest-rate payments is an inconvenient concept for those who wring their hands over the “burden” of public debt. It suggests that Powell’s rate hikes may be powerless to slow GDP. Indeed, additional rate increases could even be expansionary, at least up to a point.

US Federal Reserve chair Jerome Powell attends a press conference in Washington on July 26. The US Federal Reserve raised its benchmark interest rates by 25 basis points to the range of 5.25-5.5 per cent, the highest level in over two decades, as it continues to ramp up its fight against inflation. Photo: Xinhua

As in other extreme cases, rate hikes will increase costs for businesses, pushing up prices, and also apply price pressures on fixed assets that will show up in our inflation measures. That, in turn, will discourage saving, spur borrowing, and impel the Fed to raise rates even more.

Over time, this process will lead towards economic chaos. But, if this narrative has merit and high interest rates don’t bring on the recession that the Fed so clearly desires, it will be difficult to change course. Ideology and habit can nurture the hope that doubling down on an ineffective policy will make it work.

What might stop this dynamic? One answer is severe fiscal austerity, with budget cuts used to provoke the recession that interest rates have failed to bring about. We are already seeing pressure for this option from Wall Street.

Last week, Fitch downgraded its credit rating on US sovereign debt, in a move clearly timed to scare Congress as its budget deadlines approach. Such a policy shift, if it is strong enough, would complete the ongoing obliteration of the American middle class.

Obviously, it would be better to do the opposite – to empower the middle class and disempower the bankers. That would mean cutting interest rates while regulating new credit flows, controlling strategic prices, and strengthening fiscal support for household incomes and well-paying jobs. People with decent and secure incomes can reduce their reliance on unstable loans.

That is what we ought to do. But don’t hold your breath.

James K. Galbraith, a former executive director of the Joint Economic Committee of the US Congress, is professor at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin. Copyright: Project Syndicate