M ore than three years on, we’re having the same discussion. Inflation is still high and persistent, the same people continue to beat the dead horse of “transitory” inflation, and few are willing to address the actual problem: fiscal policy.
This week, CPI inflation came in well above target for the 38th month in a row at 3.4 percent for April, while core CPI came in at 3.6 percent. Last year, when many forecasters were predicting inflation of 2.5 percent for 2024, I wrote a National Review piece that noted inflation was likely to stay between 3 and 4 percent through 2024. The drivers of this prediction remain the same.
The Federal Reserve recently announced that it would scale back its balance-sheet reduction, slated to commence on June 1, thereby demonstrating the nuanced interplay between fiscal constraints and monetary-policy priorities. While signaling the end of quantitative tightening could, in theory, alleviate pressures on Treasury yields, it underscores a deeper concern: the cost of financing the nation’s mounting debt at a time when (not unconnectedly) interest rates have risen sharply. In fact, the cost of servicing the debt is likely to be the second largest government expense this fiscal year, after Social Security.
By the end of April, average interest rates on government debt being rolled over notched up to 3.23 percent, up from 2.58 percent last year and 1.66 percent two years ago. This doubling in interest rates looms large on the Federal budget as the maturity of U.S. debt is very short term.
In fact, 54 percent of all debt rolls over every three years, with 35 percent of all government debt rolling over every single year. In April alone, the Treasury rolled over $2.3 trillion in debt into high-interest-rate treasuries. This leaves the Federal budget notably exposed to the sharp uptick in interest rates.
As the cost of servicing interest payments balloons, the need to stop (or even reverse) the nation’s mounting debt is obvious. With no end in sight for our inflation woes, the Fed’s tactical retreat from balance-sheet reduction appears to be a calculated maneuver to mitigate this upward pressure on yields. However, in the absence of substantive fiscal reforms from Congress, this strategy risks increasing inflation to something which markets would to react by demanding higher rates. The possibility of creating a doom loop is real.
The symbiotic relationship between monetary policy and fiscal prudence cannot be overstated. As the Fed grapples with its interest rate conundrum, Congress shows no serious interest in addressing the nation’s fiscal woes. The Federal Reserve’s pivot underscores a broader systemic fragility. Without concerted efforts to rein in fiscal profligacy, the specter of persistently high (or even reaccelerating) inflation looms ominously.
When government spending is fully offset with taxes, beneficiaries of that spending acknowledge that they get transfers today, but they’ll have to pay more taxes tomorrow. In this case, saving is encouraged, and the risk of inflation is low. If, however, government spending is not backed by taxes, but instead financed by issuing bonds, then beneficiaries see these transfers as an increase in their wealth, and the risk of inflation is high. We saw this in 2020-21.
The fiscal theory of the price level offers a sobering prognosis: Absent meaningful fiscal prudence, inflation is unlikely to recede to the Fed’s coveted 2 percent target. Instead, it risks morphing into an enduring phenomenon, exacting a toll on American living standards. The Fed’s recalibration of its balance-sheet-reduction strategy represents an acknowledgment of this perilous reality, in spite of the Feds refusal to fully acknowledge its implications.
All that said, resolving this problem cannot be left to monetary policy alone. Congress must not ignore the urgent need for responsible budgeting.
Implementing fiscal rules that impose legally binding limits on the growth of both mandatory and discretionary spending programs would be a good start. Such rules would impose fiscal discipline, compelling policy-makers to prioritize a sustainable spending path.
As well as imposing spending limits on the broader budget, an additional option toward fostering fiscal responsibility could involve scrutinizing tax expenditures. Well-intentioned initiatives like the low-income-housing tax credit often have unintended consequences, such as inflating housing costs for middle-income Americans. Eliminating such inefficient tax expenditures not only promotes fairness but reduces unnecessary spending that distorts markets.
Policy-makers should also revisit the tax-exempt status of state and local municipal bonds. While these bonds serve as a financing tool for infrastructure and development projects, their tax-exempt status distorts market incentives and contributes to economic inefficiencies. Removing this tax exemption would generate almost $400 billion in revenue for the coming decade and further level the playing field for all investors by removing government-granted privilege.
Another sensible move by Congress would be maintaining the $10,000 cap on the State and Local Tax deduction after the Tax Cuts and Jobs Act expires at the end of 2025. However, to address concerns about the distributional impact of the deduction, Congress should explore additional refinements. One such refinement entails lowering the cap to $5,000 for single and head-of-household filers, as recently suggested in a proposal by the American Enterprise Institute.
The persistent high inflation underscores the urgent need for fiscal reform. While the Federal Reserve’s recent actions signal a recognition of the fiscal challenges we face, it alone cannot address the root causes of inflation. Congress must prioritize responsible stewardship of taxpayer dollars. Let’s not repeat the mistakes of the 1970s.