May The Two Forces Be With You
Updated: Aug 3, 2022
A look at the last hundred years of US fiscal and monetary policy
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A recent post reviewed this paper 1969—Battle Against Inflation about the high inflation in the US in the late 60s and noted some striking parallels with today in relation to excessive federal government spending. In the mid-60s, it was wrongly believed by certain government economic advisers that there was sufficient slack in the economy to absorb a big increase in federal outlays. There wasn't, and inflation rose from just above 1% in the mid 60s to 5% in 1969. Although inflation came down as a result of the 69-70 recession, it had become entrenched - structural - and came back with a vengeance once the recession had passed.
As for the present day, while emergency fiscal spending was certainly required in 2020 following the outbreak of covid, it is becoming increasingly clear that Biden's $1.9tr American Rescue Plan Act of 2021 was unnecessary, excessive, and inflationary. Was he badly advised? Only time - and biographies - will tell. For now, we can be thankful Biden didn't get the $3.5tr he had initially agreed with his party.
The above mentioned paper noted that the two prime motivating forces in bringing about cyclical movements in total spending are fiscal and monetary policies. Having in another recent post compared the increases in federal government spending then and now, finding that fiscal stimulus has been far greater in the last two years than it was from 1965 to 1969 and thus more inflationary, I thought it would be good to include the other major force, monetary policy, and also to look further back. The chart below is the result.
Sources: https://fred.stlouisfed.org/, https://www.measuringworth.com/, https://www.usgovernmentspending.com/
As a proxy for monetary policy I have used the monetary base rather than the Fed Funds Rate or some other metric. This is so that the two periods of unconventional monetary policy aka QE can be clearly seen: 1933 to 1945 and 2008 to now. Use of the monetary base also allows its trend growth to be measured and thus compared with total GDP and federal government spending. Also, despite much talk of the Fed reducing its balance sheet - the monetary base - the Fed has never reduced its balance sheet! At least not for long - it tried in 1937 but this caused a nasty recession and the stock market to halve.
A few things to note:
The fiscal excess of the 1965-9 is just about visible as an increase in the line's gradient but barely
The last two years of massive fiscal stimulus on the other hand are clearly visible albeit pale into insignificance compared to the two world wars and the depression years of the 30s
While the comparison between the present day and the late 60s in relation to federal expenditure is still valid, the more relevant comparison in terms of monetary policy is the 30s and early 40s
It is also interesting that despite the prevailing feeling that monetary expansion over the last 100 years must have been excessive, it is in fact bang in line with the rise in GDP - 6.8% pa versus 6.7% pa
Federal spending however has increased by 7.2% pa, exceeding GDP growth of 6.7% pa - I have excluded the years leading up to 1946 as this was a period in which the role of the federal government changed immeasurably and so distorts the trend
What can be learned from the above?
Although I have pointed to similarities with the 60s in relation to fiscal policy, a big difference was that the the 50s and early 60s did not experience deflation that required QE as has been the case in the last 15 or so years. If anything, inflation in the 50s became elevated as a result of government expenditure associated with the Korean War. And there was certainly no talk of secular stagnation at that time as there has been - or at least had been! - in recent years.
My point is, is it possible that the deflationary forces associated with secular stagnation in recent decades will come to our rescue in helping to bring current high inflation down? Yes, upward inflationary forces are currently very strong, but they will lessen as a result of the coming recession, Fed-induced or otherwise. Once inflation has eased cyclically, can the downward forces of secular stagnation keep it there structurally.
Or are we in trouble because the factors that in recent years caused developed economies to stagnate and their inflation rates to fall - cheap labour in the emerging world, for example - are no longer valid?
A recent opinion piece in the Washington Post by Larry Summers sought to address various points made in a speech by Fed Chairman Jerome Powell in March. One of Powell's points addressed by Summers was that inflation might look scary now, but it will come down as labour-force participation rises and supply-chain bottlenecks ease. According to Summers:
First, the question isn’t whether inflation will come down from about 8 percent on the current policy path. It is whether it will come down to an acceptable level. That’s a very different proposition.
Second, given new bottlenecks associated with the Ukraine war, covid-19 closures in China and rising worker restiveness, it is far from clear that new supply-chain developments will be positive. Team Transitory proved dead wrong through 2021. It may well be wrong in 2022.
Third, the optimists have their macroeconomics wrong. True, more job seekers might restrain wages. But more workers earning and spending raise demand and prices. Only if they add slack to the labor market — raising unemployment, in other words — will extra labor-force participants reduce inflationary pressure. Similar logic applies in product markets. If used-car or gasoline prices come down, consumers will have more to spend on other goods, pushing up their prices.
Given that Summers has been the leading voice on the subject of secular stagnation in recent years and its causes, one might have expected him to mention it, either in the section above or elsewhere in the article.
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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