Federal Reserve Chair Jerome Powell and other Fed leaders seem to believe that their policy of increasing short-term interest rates by 525 basis points is responsible for the progress to date on slowing inflation. They may be the only ones.
The September “Blue Chip Economic Indicators,” a monthly survey of top business economists, placed the importance of Fed tightening in perspective, to date, with the following question: “What do you think has been the major factor behind the decline in U.S. inflation over the past year?”
Among those responding, 58% said “Mending supply chains.” Another 34% said “Falling energy prices.” But only 8% responded “Tighter monetary policy.”
There are usually around 50 economists in the Blue Chip survey, so only 3 or 4 out of that group thought that jacking up the funds rate by 525 bps since March 2022 along with quantitative tightening has been the major factor behind the inflation slowdown over the past year.
CPI inflation slowed from 9% year-over-year in June 2022 to a recent 3.7% y/y increase. The major factor in that decline was improvement in supply chains, according to those taking part in the survey.
In a November 30, 2022 speech, Fed Chair Powell said: “For starters, we need to raise interest rates to a level that is sufficiently restrictive to return inflation to 2%.” To date, economists say that Fed policy has been of limited importance in slowing inflation.
The Fed’s tightening of monetary policy has its major effect on reducing inflation by slowing aggregate demand or the growth rate of the economy. Real economic growth in 2022 was 2.1%, which is roughly equivalent to the long-term growth of the U.S. economy. So, essentially, monetary policy had little effect on real growth last year.
According to September’s Blue Chip survey, inflation-adjusted economic growth is expected to be around 2.2% this year, which is about where long-term growth is. Again, sharply higher interest rates and quantitative tightening are expected to have little effect on economic growth.
Next year, however, growth is expected to slow to 1%, according to the Blue Chip consensus, which implies that sharply higher interest rates and QT will have their impact but on the 2024 economy.
That follows the expected pattern of monetary policy tightening. Fed leaders raised the federal funds rate by 425 bps in 2022. A year to 18 months later, 2024, that Fed tightening should slow economic activity and push inflation lower.
Ten of the Blue Chip members expect economic activity to average 0.3% next year, which is consistent with a mild 2024 recession during an election year. Other indicators such as inverted yield curves, which happens when short-term interest rates are pushed higher than long-term interest rates, also point to recession next year. And some think that since a recession did not occur this year, that the U.S. won’t have one.
The issue with that outlook is that the Biden administration’s fiscal policy of excess federal spending has acted to prop up both economic growth and inflation, delaying a recession until next year.
Federal spending in 2023 is roughly two percentage points higher than before 2020 as a proportion of GDP, which is why this year’s federal deficit is running about $600 billion higher than last year’s deficit.
In addition, Biden Administration policies have clogged up the supply chain and tamped down the labor force participation rate. Inflation may have been close to the Fed’s 2% target by year-end 2023 if not for Biden policies.
Those policies included limiting fossil fuel production in the U.S. by halting new oil and gas leasing on federal lands, onshore and offshore, in January 2021. That policy pushed up oil prices and therefore inflation throughout the transportation supply chain.
Biden’s $1.9 trillion American Rescue Plan, in March 2021, gave cash to the vast majority of U.S. households, whether they were working or not. That held down the labor force participation rate, as many otherwise able workers stayed out of the workforce. Now, that excess cash is drying up and, as expected, the labor force participation rate is ticking higher.
Biden’s Inflation Reduction Act of 2022 allocated capital to particular industries, putting the federal government in the business of trying to pick winners and losers. Everyone knows how that turns out – misallocation of capital and fraud, further slowing the ability of the U.S. economy to produce goods and services.
Biden policies kept economic growth elevated in 2023 to avoid a recession, which pushed the recession into 2024. If Mr. Biden is still in the race for president, he may have a difficult time with voters who have been beaten up with high inflation for three years followed by a 2024 recession.
Mike Cosgrove, principal at Econoclast, a Dallas-based capital markets firm, is an emeritus professor at the University of Dallas.