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Fed rate hikes won’t bring down inflation as long as government spending stays high, paper says

  • A paper released at the same Jackson Hole, Wyoming, summit where Fed Chair Jerome Powell spoke suggests the central bank can't do the job itself and could make the matters worse with rate hikes.
  • The paper argues that without constraints in fiscal spending, rate hikes will make the cost of debt more expensive and drive inflation expectations higher.
  • Many economists, however, expect a variety of factors will conspire to bring inflation down, helping the Fed do its job.

John C. Williams, president and chief executive officer of the Federal Reserve Bank of New York, Lael Brainard, vice chair of the Board of Governors of the Federal Reserve, and Jerome Powell, chair of the Federal Reserve, walk in Teton National Park where financial leaders from around the world gathered for the Jackson Hole Economic Symposium outside Jackson, Wyoming, August 26, 2022.Jim Urquhart | Reuters

Federal Reserve Chair Jerome Powell proclaimed Friday that the central bank has an "unconditional" responsibility to ease inflation and expressed confidence that it will "get the job done."

But a paper released at the same Jackson Hole, Wyoming, summit where Powell spoke suggests policymakers can't do the job by themselves and actually could make matters worse with aggressive interest rate increases.

In the current case, inflation is being driven largely by fiscal spending in response to the Covid crisis, and simply raising interest rates won't be enough to bring it back down, researchers Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed wrote in a white paper released Saturday morning.

"The recent fiscal interventions in response to the Covid pandemic have altered the private sector's beliefs about the fiscal framework, accelerating the recovery but also determining an increase in fiscal inflation," the authors said. "This increase in inflation could not have been averted by simply tightening monetary policy."

The Fed, then, can bring down inflation "only when public debt can be successfully stabilized by credible future fiscal plans," they added. The paper suggests that without constraints in fiscal spending, rate hikes will make the cost of debt more expensive and drive inflation expectations higher.

Expectations matter

In his closely watched Jackson Hole speech, Powell said the three key tenets informing his current views are that the Fed is primarily responsible for stable prices, public expectations are critical and the central bank cannot relent from the path it has drawn to lower prices.

Bianchi and Melosi argue that a commitment from the Fed simply isn't enough, though they do agree on the expectations aspect.

Instead, they say that high levels of federal debt and continued spending increases from the government, help feed the public perception that inflation will remain high. Congress spent some $4.5 trillion on Covid-related programs, according to USAspending.gov. Those outlays resulted in a $3.1 trillion budget deficit in 2020, a $2.8 trillion shortfall in 2021 and a $726 billion deficit through the first 10 months of fiscal 2022.

Consequently, federal debt is running at around 123% of gross domestic product — down slightly from the record 128% in Covid-scarred 2020 but still well above anything seen going back to at least 1946, right after the World War II spending binge.

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