Jerome Powell and the Coming Inflation

Usually, the Federal Reserve acts as a counterweight when Congress and U.S. presidents follow inflationary policies. We haven’t had an incompetent Federal Reserve chairman since Arthur Burns and G. William Miller produced simultaneous inflation and recession, an economic malady known as “stagflation.” Federal Reserve Chairman Jerome Powell may not be as bad as Burns and Miller, but he does seem to be making one economic mistake after another.

Like Miller, Powell is that rare exception: a Fed chair without a background in economics. Being an American today is a bit like riding on a bus driven by someone who lacks a CDL.  It might work out okay, but some white knuckles on the curves are well justified.

Powell’s First Mistake – Raising Interest Rates under Trump

Powell’s first mistake occurred when he raised interest rates during President Trump’s successful economic boom that occurred without inflation. President Trump’s economic advisor Peter Navarro indicated that this might have cost Trump the election (at about the 10-minute mark):

Everybody knows me and Mnuchin weren’t exactly bosom buddies. Whenever I wanted to put a little dig in Steve all I had to do was remind the boss [President Trump] that it was Mnuchin that appointed Jay Powell who the boss thought was the worst Fed Chair in modern history who cost us the election because that SOB raised interest rates well before he should have.

Powell’s increase in interest rates was not needed because President Trump’s supply-side economics was simultaneously increasing Aggregate Demand and Aggregate Supply, and thereby producing economic growth with little change in price level.

Powell’s Second Mistake –Promising to Let Inflation Take Off

In response to the pandemic, Powell has engaged in policies that have massively increased the money supply, an increase that has not yet produced major inflation, partly because of time lags and partly because the pandemic has dramatically reduced the velocity of money in the economy. If enough Americans get vaccinated, pandemic restrictions will ease, and the velocity with which money changes hands will climb, along with inflation.

And Powell will let that inflation get going without doing anything about it. He promised, in a 60 Minutes interview, to delay any rise in interest rates during Biden’s upcoming boom until well after inflation takes off.

He may be hoping to avoid the mistake that he made by raising interest rates, unnecessarily, during the Trump boom. We have boldfaced the part of the interview in which he mistakenly confounded Trump’s and Biden’s very different economic strategies:

YouTube screengrab (cropped)

SCOTT PELLEY: What the Fed has done traditionally is use economic models to predict inflation and then raise interest rates, tap the brake if you will, before inflation happens. Is that what you're planning on doing?

JEROME POWELL: No, it's not. And really, what we've done is we've updated our understanding of the economy and therefore, our policy framework to the way the economy has evolved. The economy has changed. And what we saw in the last couple of cycles is that inflation never really moved up as unemployment went down.

But Biden is following a very different economic strategy from the supply-side economics used by Trump. He is planning to raise government spending and taxation simultaneously. The result would be Aggregate Demand increasing with new government expenditures while Aggregate Supply contracts as taxation reduces the payoff for business and human investment.

Economic research shows that changes in taxation are 2 to 3 times more powerful than changes in government spending as far as economic growth is concerned. Specifically:

  • Christine Romer, former Chair of Obama’s council of economic advisors, and her husband Paul have found that changes in taxation have a powerful effect upon Real GDP with a multiplier value upon Real GDP of between 2.5 and 3.0.
  • Valery A. Ramey has found that increases in government spending have a multiplier effect upon Real GDP of between 0.8 and 1.5.

Under Biden, government spending and taxation levels will be pulling economic growth in opposite directions. But Biden’s spending increases will be so massive that, despite their weaker multiplier, they should overcome the opposing effects of his tax increases. (The spending increases will increase demand while the tax increases will reduce supply.)

Together, Biden’s massive increase in government spending and his increased regulations and taxes will boost inflation, especially when coupled with the massive increase in money supply Powell has engineered and the increased velocity with which money will change hands following easing pandemic restrictions.

But Powell plans to do nothing until the inflation takes off. When the Federal Reserve finally starts upping the interest rate, it will take at least 6 months before higher interest rates begin to have any effect. Meanwhile the rising inflation rate will get its own momentum due to inflationary expectations potentially getting embedded into almost every new contract that is negotiated.

Powell’s Third Mistake – Slowing Fossil Fuel Investment

To promote the maximum switch to renewable sources of fuel, Powell plans to discourage banks from making loans to fossil fuel developers. Republican senators have been objecting:

Last month, 12 Republican senators wrote a letter to Powell accusing the central bank of moving “beyond the scope of the Federal Reserve’s mission.”

“We question both the purpose and efficacy of climate-related banking regulation and scenario analysis, especially because the Federal Reserve lacks jurisdiction over and expertise in environmental matters,” the letter said.

Powell will be intentionally reducing Aggregate Supply, by reducing loans for private investment into U.S. fossil fuel production. That investment was one of the main drivers of economic growth during the Trump administration.

Powell’s Fourth Mistake – Endorsing Trade Deficits

Trump’s former economic advisor Peter Navarro predicted that the coming inflation will especially harm blue collar workers. Trends in that direction are already apparent in recent statistics and news. The U.S. post-Covid economic boom is already being accompanied by (1) rising inflation, (2) rising trade deficits, and (3) the moving abroad of planned manufacturing investment.

Navarro was especially concerned by Powell’s statement in the 60 Minutes interview that he is counting on increased trade deficits to prevent inflation. Specifically, Powell said:

[T]he economy has changed because the globalization of the economy and technology have enabled manufacturing to take place all around the world. It's very hard for people in wealthy countries to raise prices or to raise wages. It's hard for workers to raise wages when wages can move overseas….

U.S. blue-collar wages and U.S. manufacturing investment rose under President Trump, partly because Trump ended or renegotiated unbalanced trade agreements. But instead of endorsing continuing efforts to restrain trade deficits, Powell is counting upon the increased trade deficits to keep inflation low by restraining the wage demands of manufacturing workers.

America’s Economic Future

Powell’s first four-year term at the Federal Reserve ends in February 2022. At that point, the Biden administration will likely reappoint him to a second term so that he can continue to restrict loans to fossil-fuel developers and continue to keep his feet off the interest-rate brakes.

Eventually, Powell or his successor will discover that it is a lot easier to let inflation get started than it is to bring it under control. Once the Fed puts on the brakes, Biden’s sugar high will turn into a post-sugar crash due to rising interest rates and rising trade deficits.

The worst-case scenario would occur if foreigners stop using the inflating dollar as the medium of exchange in international transactions, resulting in a crash in the dollar’s exchange rate, much higher prices for imports, and a huge cut in the American standard of living. China appears to be preparing for that scenario by rolling out a digital yuan that could be used as an alternative to the dollar for international transactions.

The Richmans co-authored the 2014 book Balanced Trade published by Lexington Books, and the 2008 book Trading Away Our Future published by Ideal Taxes Association.

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