The Inflation Tail Is Wagging the Policy Dog

NEW YORK – With prices in many advanced economies surging, central banks are being roundly criticized for falling “behind the curve” on inflation. But they didn’t. Government policies and geopolitics constrained central bankers from normalizing their monetary policies until inflation was already upon them. Chinese and Russian supply-chain disruptions collided with the synthetic demand created by the US Department of the Treasury mailing free money to American consumers.

There is now very little room for monetary tightening without stalling the economy (which is already faltering under tightening financial conditions). But make no mistake: the window to tighten monetary policy was missed because of decisions made by political leaders. It is they who bear responsibility for fixing the problem, keeping in mind that the longer-term economic environment is still defined by the “three Ds”: rising debt, demographic aging, and disruptive labor- and demand-displacing technologies. In these conditions, persistent disinflation is more dangerous than episodic inflation.

In retrospect, it is clear that the US Federal Reserve and other central banks were forced by political leadership to defer policy normalization (a prerequisite for responding effectively to the next crisis) while the economy was strong in 2018. When the pandemic hit, former President Donald Trump’s administration and Congress panicked, directing the Treasury to borrow trillions of dollars to finance “economic impact payments” to stimulate consumer demand. Then in 2021, Joe Biden’s newly installed administration essentially repeated the process.

The newly issued short-term Treasuries were bought by the Fed, which more than doubled its balance sheet over the past two years, increasing its holdings from $4 trillion to $9 trillion (nine times higher than its mid-2008 level of less than $1 trillion). The consequences were predictable. As the Nobel laureate economist Milton Friedman famously argued, inflation is “always and everywhere a monetary phenomenon … produced only by a more rapid increase in the quantity of money than in output.” More money chasing the same output of goods and services means higher prices.

Ordinarily, the Fed could raise rates, cooling excess demand long enough for supply to catch up. But this time, the intersection of geopolitics and pandemic-recovery dynamics yielded both surging demand and delayed supply.

Fortunately, with consumers having spent their stimulus checks, the latest data suggest that inflation is peaking. And it should decline further as private businesses repair product supply chains without waiting for government. But now that the market has finally been conditioned for rate hikes, the more immediate danger is an over-tightening of financial conditions.

Inflation might soon be forgotten as central banks pursue quantitative tightening (QT) – selling down the holdings that they have amassed after 15 years of bond buying. For its part, the Fed is targeting a $1 trillion (or 11%) reduction in its Treasury holdings over the coming year.

The problem is that when the Fed sells Treasuries, it effectively drains liquidity from markets at prices that private markets set regardless of policy rates. Hence, ten-year Treasury rates already jumped from 1.9% to 2.7% in the past month, and the Fed has only just begun the first of its three most modest asset sales ($47.5 billion per month between June and August of this year).

In the meantime, a lot could go wrong from a fiscal perspective. Consider that $24 trillion of US sovereign debt is publicly held with an average maturity of about five years. That means an increase of two percentage points in interest rates over the next five years would add nearly $500 billion to the federal government’s current debt-servicing burden of $352 billion. The current $3 trillion federal budget deficit thus would increase by nearly 20%, more than offsetting savings from the end of COVID “economic impact payments.”

To be sure, the incremental cost of the first $1 trillion of Treasuries the Fed sells might be manageable. But consider the interest-rate and budgetary implications of the Fed selling off another $3 trillion to return to 2020 levels, let alone another $7 trillion to return to 2009 levels. Talk about crowding out non-discretionary spending: Interest payments on federal debt might well become the largest single item of national expenditure – though the costs of social security, health care, and national defense are also set to rise substantially in the coming year.

Absent politically untenable tax increases, US fiscal deficits and total debt are poised to rise to new highs. Meanwhile, the junk bond market has mushroomed to more than $3 trillion outstanding, and is heavily skewed toward lower-quality issuers. As those issues mature, we should expect to see a significant number of “zombie” companies that must restructure because they cannot refinance at higher rates.

But this is assuming that any material tightening happens at all. The economy appears to be heading toward recession before policy-rate increases have reached a full percentage point, and before QT has even started. US GDP growth is foundering, and the employment situation is considerably less rosy than it looks. The low headline unemployment rate of 3.6% does not account for the fact that only 62.2% of eligible employees are even looking for jobs. The available jobs seem to be ones that nobody wants.

Moreover, as artificial intelligence and other software technologies become more advanced, they will increasingly displace both unskilled manual laborers and skilled service professionals. Wall Steet bankers, traders, investors, and lawyers everywhere might soon find their jobs at risk. They should consider themselves lucky enough still to be employed – even if that means going back to the office.

Navigating these crosswinds and rough seas will require many waves to break gently. It would certainly help if policymakers stopped looking for the fastest and easiest way out and instead resolved to act strategically on national and global economic and political goals.