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Ultimately, inflation is always and everywhere a monetary phenomenon

May 06, 2022
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Ultimately, inflation is always and everywhere a monetary phenomenon, as the late great economist Milton Friedman used to say. And so the key to reducing the inflation we're experiencing today – the highest inflation in forty years – is the Federal Reserve raising short-term interest rates, like it did on Wednesday, as well as pursuing an aggressive course of Quantitative Tightening selling Treasuries.  

But the central importance of monetary policy doesn't mean other policies can't play any role at all wrestling inflation under control. Central banks don't just exist on the blackboards of academic macroeconomists; they exist in the real world where other officials adopt policies that sometimes make central banks' jobs easier and sometimes make them harder.

One key issue is the size of government, both spending and regulation. When the federal government spends money like a drunken sailor, as it did during COVID lockdowns, a central bank policy that sets short-term interest rates at essentially zero is going to generate a larger increase in the money supply and, in turn, a larger increase in inflation, than would otherwise be the case. Think of extra government spending as monetary kindling. It doesn't create fire by itself, but it does make it easier to spread.

So, one way to help the Fed more easily achieve its goal of reducing inflation would be for Congress and the President to find ways to reduce spending. Entitlements, discretionary spending, you name it. No, I am not being naïve; I know this isn't happening in 2022. But if it did, inflation would be easier to fight. 

In addition, regulations that stifle economic growth could be trimmed, particularly in the energy sector, where the government has directed resources toward politically-favored but relatively inefficient "renewables," like wind and solar, while stifling development of nuclear power, for example. A world with cheaper, more abundant, energy supplies is one in which real economic growth is faster, which means less of the increase in the money supply winds up generating inflation.

Another area ripe for regulatory reform would be the Jones Act, which dates back to 1920 and requires ships carrying goods between US ports be built, owned, and manned, by American firms. No one is talking about letting North Korea, Russia, or Cuba run these ships. But there are plenty of US allies who could qualify and who could help reduce shipping costs.

Big picture: policymakers should commit to making sure the public knows another COVID-related lockdown is not in the cards, by admitting it was a massive mistake to lock things down in the first place. 

Last, but never least, policymakers should consider cutting tax rates to boost work and investment, which, as always, help boost the economy and make inflation easier to control. 

Yes, monetary policy is the key ingredient for reducing inflation, but getting other policy oars rowing the right direction can make the Fed's job easier.

That being said, what about the downturn in the economy? 

New data showed the US economy shrinking in Q1 for the first time since the pandemic crash. Core parts of the economy, like consumer spending and business investment, actually had a strong quarter.

Two of the biggest drags on growth are somewhat temporary. 

The US economy just contracted for the first time since the intense lockdowns of early 2020. But there's no reason to panic. Gross domestic product remains the benchmark for tracking the performance of a national economy, and data out last Thursday morning painted an alarmingly bleak picture of how the US is doing. The American economy shrank at an annualized rate of 1.4% falling extremely short of the median forecast for 1.1% growth and reversing course from the fourth quarter's 6.9% print.

Despite that scary headline number, the details of the report and most other economic yardsticks show the recovery is trucking along just fine. The economy isn't as dismal as headline GDP suggests. The headline contraction in GDP "obscures the resilience of the domestic economy," Diane Swonk, chief economist at Grant Thornton, said in a Thursday tweet

Data published earlier in April showed the jobs recovery still charging forward and retail spending at an all-time high by the end of the first quarter. Other details in the GDP report back up the encouraging outlook, with consumers and businesses alike still spending big.

Americans' spending, which makes up about two-thirds of the overall economy, saw a 2.7% jump, suggesting that demand remains strong even in the face of high inflation. That was fueled by a 4.3% increase in spending on services, a welcome improvement after lockdowns and virus waves starved the sector of much-needed activity.

The uptick signals "consumers' wallets remained 'open for business'" despite high inflation, and spending growth is likely to pick up in the second quarter as more households indulge in travel and leisure, Greg Daco, chief economist at EY-Parthenon, said.

Business investment also picked up in the three-month period, providing another lift to overall output, suggesting that employers still see strong potential for future growth and are pouring money into expanding their operations.

Altogether, consumer spending, private investment, and the strength of the housing market added more to GDP in the first quarter than in the fourth, signaling the domestic economy actually accelerated through the start of 2022, Swonk said.

The headline number was dragged lower by temporary problems

For starters, a drop in business inventories put a huge damper on economic output. The final months of 2021 saw firms build up their stockpiles to counter the effects of lingering supply-chain issues. That rush played a major role in boosting growth through the end of 2021. But with the inventory build-up having played out, firms cut back on such investment in 2022.

That pullback alone subtracted 0.8 percentage points from the headline GDP rate, Jason Furman, a professor of economics at Harvard University and former chairman of President Obama's Council of Economic Advisors, tweeted. 

Trade figures put an even bigger drag on the growth gauge. The first three months of the year saw imports remain high while exporting dropped to the weakest pace since the second quarter of 2020. Since imports count negatively toward GDP, the shift subtracted a full 3.2 percentage points from growth, according to Furman. Put differently, economic output would've handily exceeded forecasts if the trade deficit wasn't so large.

The fault only partially lies with the US. Part of the reason for such high imports comes down to Americans' voracious spending appetite. On the other end of the trade equation, exports were mostly lower due to weaker demand abroad. The US has enjoyed a uniquely demand-strong recovery while other economies have generally seen high inflation have a bigger effect on spending. As such, demand for US goods and services overseas was subpar through the quarter.

While the economy is faring better than the GDP report suggests, it's unlikely the country repeats the stellar rebound seen through 2021. The US will likely experience slow growth later this year as inflation bites into spending and the Federal Reserve lifts interest rates, Matthew Sherwood, global economist at the Economist Intelligence Unit, said.

Still, the US is "in much better shape than the headline figure would imply," and it's unlikely the country enters a new recession "given the underlying health of the domestic economy," 

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