Recession Temporarily Slows Inflation. Proper Action Needed Now.
Inflation fell in July mostly because of the current recession in many of the world’s economies, including the U.S. and China, the world’s largest economies. The annual inflation rate fell from 9.1% to 8.5%. Many biased economists say that it is a sign that inflation has peaked and will soon fall. Unfortunately, that is not correct.
In July of this year, the monthly Consumer Price Index (CPI) increased 1.3% from June. That pushed the annual CPI to 9.1%. In July the 0.6 percentage point monthly CPI decrease the annual inflation rate to 8.5%. The reason for the startling drop in July was almost entirely due to the falling price of energy, which accounts for nearly three-tenths of the monthly number.
In addition, import prices fell 1.4% last month.
Inflation to Rear Its Ugly Head Again
The pause in inflation will continue into next month. Beyond that, there are still inflationary pressures building, which will re-surface in the Fall. Both the U.S. and the Chinese economies should begin to recover in the fourth quarter. That will return demand to the energy market.
Since energy supplies will not increase and may, indeed, decrease due to geopolitical forces, oil will return to the $100-plus price per gallon.
At the same time, the U.S. government continues to deficit spend. In fiscal 2020 and 2021, the government deficit spent nearly $6 trillion, which is entirely inflationary excess demand
In fiscal year 2022, the federal government deficit will exceed $1 trillion. This will continue to add excess demand to the economy, which will increase inflation. With producer prices rising at nearly 10% and food prices expected to soar, higher inflation will surely return.
Since the U.S., and many of the world’s economies, are experiencing high inflation with stagnant growth, we are in a period of stagflation. The last time this problem occurred was during the late 1970s. To right the economy, action like what was done in the early 1980s is needed. That included both monetary and fiscal policy actions.
Today, the Federal Reserve is taking action similar to what was taken in the early 1980s. At that time, inflation had reached double-digit levels. The Fed raised interest rates to double-digit levels. That action took enough demand out of the economy to bring inflation down. But there was a severe recession.
To end the recession, government cut tax rates for all Americans, including the highest-income earners who provide capital for expansion. At the same time, regulations were cut. These supply-side incentives put the economy on a 25-year growth spurt, with the exception of two minor hiccups in 1991 and 2001. And it ended the recession. By 1984, annual economic growth reached 7.4%.
Also, in the early 1980s, the government attempted to reduce demand by cutting government spending. Unfortunately, the military had been decimated in the 1970s, so military spending had to increase.
Yet More Government Spending
Today the Biden administration is taking exactly the wrong action.
Biden’s Inflation Reduction Act will increase government spending by hundreds of billions of dollars while raising taxes by an even larger amount. This will make inflation worse — and it will extend the length of the recession.
The increased spending on social programs and climate change will add more excess demand to the economy. That will increase inflation.
Biden disagrees, saying he will raise taxes more than he is increasing spending. So, he says, the act will not have any impact on total demand or on inflation. That’s incorrect.
Biden says he is raising taxes on the wealthy only. When taxes are raised on the wealthy, their spending stays about the same, but they have less savings and investment. If their spending stays the same, there is no reduction in demand, so Biden’s increased spending is inflationary.
Worse, in the longer term, with the wealthy saving less, there is less new capital created, which tends to slow growth in a capital-intensive economy. Slowing growth means less, which is yet another factor that will extend the recession.
While many seemingly biased economists will say that the low inflation numbers this summer mean the inflation problem is diminishing, the reality is, that the inflation pause this summer, is just that: an inflation pause. Unless the Federal Reserve increases its interest rate hikes and the Biden administration changes its fiscal policy, inflation will accelerate this fall.
Once inflation gets embedded into the economy, it is very difficult to stop. The time for proper action is now.
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