Thursday 28 Mar 2024
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This article first appeared in Forum, The Edge Malaysia Weekly on February 28, 2022 - March 6, 2022

Most people in the West, including economic analysts, have been ignoring inflation. Instead, for the last three decades, they’ve focused their attention on the other bogeyman, recession. But inflation in the US has reared its ugly, threatening head once again, and poses a major problem for every nation in the world. And politically, it threatens the presidency of Joe Biden.

Until inflation begins to wreak havoc on an economy, consumers and politicians tend to treat it as, at worst, a minor nuisance. Consumers dislike rising prices, but since inflation almost always is accompanied by higher wages (as it is now), its effect is muted. And politicians, who should know better, resist fighting inflation because doing so means less spending, and spending is popular with most voters.

The Covid-19 pandemic caused governments around the world, as in the US, to rapidly and generously increase spending, especially with stimulus packages providing individuals and businesses immediate monetary relief. And for the most part this was done without any sort of plan to pay for these programmes and giveaways. But this alone did not cause the inflation problem, it merely revealed and exacerbated it.

Many analysts point to the supply-chain back-up as the main reason for the newly realised inflation outbreak. But this is only one part of the problem that has been in the making for years, as governments have pursued reckless fiscal policies, mostly for political purposes and to artificially spur growth through greater building, investing and consumer spending. Now is the time of reckoning, with frighteningly high inflation threatening workers, companies and consumers worldwide.

Central bank officials, especially those in countries with strong domestic economies, surely are concerned about the prospect of rising inflation rates. But this concern should be shared by the rest of us.The problem we all face today is twofold: First, speedy and steady inflation looms as a serious risk, especially as consumers resume their old shopping ways without restraints as they buy in-person. Second, most people today are too young to have experienced the dreadful consequences of inflation, and most of us who do recall its appearance have long forgotten how bad it can be — and this results in widespread ignorance about the menace.

The US central bank, the Federal Reserve, has two charges: to promote maximum employment and to promote price stability. The first of these is far more attractive to politicians, of course, because it means flooding the economy with more money and more jobs. But the Fed is not supposed to make its decisions based on short-term political gain (which it does not benefit from anyway). Its job is to balance the two charges for long-term economic growth. Yet, since inflation became a very visible and persistent threat last year, the Fed has continued to focus only on its first charge.

Under President Biden, the reappointment of Jerome Powell as Fed chairman, along with the appointment of Janet Yellen, the former Fed chair, as Treasury Secretary, led many to believe that wisdom would prevail in the areas of fiscal and monetary policy. But such confidence was misplaced.

Powell said, “We understand that high inflation imposes significant burdens, especially on those less able to meet the higher costs of essentials like food, housing and transportation. We are committed to our price-stability goal. We will use our tools both to support the economy and a strong labour market and to prevent higher inflation from becoming entrenched.” But the slowness of the Fed in addressing steadily rising prices suggests that he is far more concerned with the labour market than he is with the onslaught of widespread inflation.

And Yellen, who should know better, oddly declared that simply by improving GDP, inflation would return to a more normal state. She claimed that a booming economy would temper inflation. But such an utterance sounds much more like political, rather than economic, dialogue. First, how in the world does an economy with more jobs at higher wages cause an ease in prices? And second, if Yellen is correct, why is inflation rising so rapidly as the US experiences impressive GDP gains? Those who take Yellen at her word seem to believe, or perhaps hope, that once the supply-chain problem subsides, so will inflation. But a better plan for central banks everywhere would be recognising that inflation can only be met head-on by enacting sound monetary policies.

To be fair, Secretary Yellen isn’t the first member of a presidential administration to utter nonsensical advice concerning inflation and the economy. In 1974, then US president Gerald Ford, responding to rising inflation rates, appeared before Congress, called inflation “public enemy number one” and begged the American people themselves to bring the problem under control by saving more and tempering their spending practices. He began this foolish campaign with a “WIN” (Whip Inflation Now) slogan, which quickly became fodder for late-night jokes, and was ridiculed by scores of experts on finance and economics. It failed, of course, because the basic laws of supply and demand do not react to political campaigns.

So, how should the Fed respond to the threat of inflation?

In 1980, the US was reeling from an inflation rate of 14.8%. By 1983, thanks to then Fed chairman Paul Volcker, the rate was down to below 3%. He achieved this reduction by taking a variety of steps to control the level of money in circulation. This involved raising the federal funds rate — the rate at which commercial banks lend one another money overnight. From 1979 to 1981, Volcker’s Fed jacked up this rate from 11.2% to 20%. This caused the prime rate — the short-term rate for the best business customers — to soar to an all-time high of 21.5%.

Inevitably, this greatly reduced the amount of money in circulation and contributed mightily to the national recession of 1980-1982. But by 1982, the inflation dragon was slain, the Fed once again eased monetary policy, and the roaring economy of the 1980s began.

When Volcker took the helm at the Fed, inflation was a menace with which Americans were not familiar. Since the early 20th century, annual inflation has increased an average of 3%, which facilitated healthy levels of business and personal borrowing. And since the 1950s, a robust housing market, where buyers could take out long-term loans for about 6%, was something Americans came to expect. For this to continue, however, banks and other lending institutions had to rely on relatively low rates of inflation, so that their long-term loans could continue to be profitable.

Volcker’s frontal assault on inflation initially caused ordinary Americans, as well as financial analysts, anguish and fear — mainly because they had no assurance that his plan would work, and no good guess as to whether double-digit interest rates would remain the norm, perhaps indefinitely.

It is worth noting that Volcker’s strategy was essentially the same one pursued by a long-forgotten Fed chairman, William McChesney Martin, who ran the Fed for nearly two decades during the 1950s and 1960s. Martin knew that a brisk economy is at risk when it features an abundance of easy money, so he refused to provide it, while keeping interest rates — which are, simply, the cost of money — high enough so as to discourage excessive borrowing, spending and investment. His strategy fostered two decades’ worth of steady growth without punishing inflation.

It isn’t just the public that is burdened by short memories or insufficient grounding in history, it is the “experts” as well. The fact of the matter is, Volcker’s plan worked. And there’s nothing complicated about what that tells us: fiscal policies are important but, unlike monetary policies, have little to no effect when it comes to battling inflation.

Last month, the president of the New York Federal Reserve Bank said the Fed could raise interest rates “as early as March”. The sooner the better, as history has shown. Powell ought to emulate his successful predecessors, by immediately tightening the money supply and hiking interest rates, perhaps in an emergency meeting of the Fed.

For the US and Biden, inflation looms as the most serious threat in the near future. Fiscal policy, over which the US president has a fair measure of control, can help only slightly with inflation.On the other hand, the Fed’s monetary policies, largely ineffective in battling recessions, can knock the wind out of inflation, as former chairman Volcker demonstrated.


William G Borges is a professor at HELP University in Kuala Lumpur. Caleb J Crocker teaches economics and political science at a college in Florida, the US.

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