West Virginia senator Joe Manchin has seized control of the public spending debate in Washington, insisting on cutting the program outlined by US president Joe Biden before he will support its passage.
A key explanation of Manchin’s is the higher-than-usual rate of inflation the US has experienced as it emerged from the pandemic recession over the course of 2021. In calling to hold back public spending, Manchin has cited “runaway inflation,” and in a negotiating document leaked yesterday, he demanded that the Federal Reserve end its asset-purchase programs before he would vote for a government spending bill.
The Oct. 1 report on personal consumption expenditures (PCE), the Fed’s preferred inflation measure, provides some illuminating data connected to Manchin’s concerns—and suggests they don’t make any sense.
The Bureau of Economic Analysis found that prices rose 4.3% year-over-year in August, a 30-year record and a more rapid pace than policymakers desire. But from July to August, prices increased just 0.4%, down from their March high, and the same as June to July.
What kind of inflation is the US experiencing?
Federal Reserve chair Jay Powell expected inflation in 2021, but not this much. Still, the new reading does suggest that the central bank, which updated its 2021 inflation forecast this month to 4.3%, might get ahead of the curve if the rate falls modestly. (PCE inflation thus far in 2021 is 3.3%.) Bond markets aren’t panicking, either, with interest rates largely unchanged after the news.
As another inflation measure, the consumer price index, suggested earlier this month, it’s hard to say that inflation is running away. But it might be plateauing at an uncomfortably high level.
The debate thus far has been about whether these high prices are the temporary result of reopening the pandemic economy with support from the Fed and public spending, or if these price increases are becoming a new normal driven by some other mechanism, perhaps rising home prices, ongoing supply chain hiccups, or demands for higher wages.
So far, home prices and wages haven’t shown themselves as drivers of price increases. Despite concerns about rising wages for food service workers, prices paid for food services actually fell in August. Supply chain hiccups are still a problem, particular around imported goods, though some of the goods that were driving price increases earlier in the year, like used cars, actually saw prices fall in August.
Fossil fuel prices are driving US inflation
Now, it’s increasingly clear that what’s driving inflation is the price of fossil fuel: The cost of gasoline rose faster than any other price in August and year to date. That’s tied to demand increases as the world emerges from the pandemic recession and producers expand capacity.
What about government spending? It certainly played a role in driving up price increases by supporting citizens with direct cash benefits, alongside other measures to keep the economy afloat. But even if Biden’s spending plans are enacted without further cuts, US spending will fall by $1 trillion and borrowing will plunge by nearly $2 trillion in 2022 compared to 2021, a massive reduction in public economic activity.
Because of how long the Fed has undershot its inflation targets, its economists don’t see a brief period of faster-than-normal price hikes as a big deal. But, just like Manchin, they do want to be confident in predicting it will subside.
What could tame inflation?
Manchin wants the Fed stop its quantitative easing (QE) program, through which it purchases Treasury bonds and government-backed mortgage debt. The program is used by the Fed to stimulate the economy and also to help show markets when it will make moves on interest. First attempted in the wake of the 2008 financial crisis, QE helped increase employment, analysis suggests, and there’s no sign that it boosted inflation during that period.
Luckily for Manchin, the Fed is already plotting to wind down QE before the end of 2021, as more Americans find work. The move may reduce demand slightly, but it’s unlikely to affect the pace of price increases that aren’t clearly tied to monetary policy. Even interest rate hikes, which few expect this year, are unlikely to solve the problem.
“The Fed can hike interest rates all it wants, it’s not going to make it rain in Brazil, open ports in China, find truck drivers in the UK, change covid-0 policies in Australia,” Frances Donald, the chief economist at the British investment manager ManuLife, wrote on Twitter, outlining a range of supply factors that are driving up prices around the world.
That puts monetary policymakers in a thorny position. Their tools are squarely aimed at demand; lowering it through tighter policy would lead to lower prices—but also to more people out of work and slower growth, at a time when forecasters are already seeing headwinds in the economy and the extra financial compensation for unemployed workers has expired.
Infrastructure spending could also keep a lid on inflation
Ironically, the legislation that Manchin is blocking, a bipartisan infrastructure bill and an annual spending bill, contains some of the better ways to ease price increases: investments in ports and other transportation systems, policies to cut drug prices, funds to construct new homes and apartments, and plans to expand access to renewable energy.
None of that will take affect overnight, but it would be constructive—especially since supply constrictions will only become more common as climate change impacts the planet. Tightening monetary policy now, on the other hand, would certainly damage the economy, and might change little about the real problems behind the price increases.