Just before Christmas, Congress passed a massive omnibus spending bill. This is yet another blow to the Federal Reserve’s feckless fight against inflation.
The $1.7 trillion bill will fund government operations for the remainder of fiscal 2023. It includes some $800 billion in domestic spending, a 9.3% increase over fiscal 2022. It also includes $858 billion in military spending, a 10% increase over last year’s levels.
Overall, the omnibus bill authorized about $1.5 trillion more than last year’s budget.
“Yes, indeed the goose is getting fat—we have a big bill here because we had big needs for our country,” House Speaker Nancy Pelosi said.
Of course, this is only one component of federal expenditures. In March 2021, Congress approved $1.9 trillion in spending to address the pandemic, and earlier this year, it passed the euphemistically named “Inflation Reduction Act.” All of that spending will pile on top of this most recent allocation of funding.
Of course, all of this spending will only increase inflation.
And it’s a big problem for the Federal Reserve as it attempts to stem the tide of rising prices.
In fact, it is impossible for the central bank to get a handle on inflation when the government keeps running bigger and bigger deficits that can only be sustained by more inflation.
The Fed’s Problem
The Federal Reserve has primarily relied on interest rate cuts to battle inflation. But it can’t slay the inflation dragon with monetary policy alone. A paper published by the Kansas City Federal Reserve Bank even acknowledged that fact. In a nutshell, the authors argue that the Fed can’t control inflation alone. US government fiscal policy contributes to inflationary pressure and makes it impossible for the Fed to do its job.
Trend inflation is fully controlled by the monetary authority only when public debt can be successfully stabilized by credible future fiscal plans. When the fiscal authority is not perceived as fully responsible for covering the existing fiscal imbalances, the private sector expects that inflation will rise to ensure sustainability of national debt. As a result, a large fiscal imbalance combined with a weakening fiscal credibility may lead trend inflation to drift away from the long-run target chosen by the monetary authority.” [Emphasis added]
And why does the private sector expect more inflation in order to sustain the debt? Because ultimately the central bank has to monetize that debt. That means money printing in order to buy US debt. Without the Fed intervening in the bond market, the US Treasury cannot sell enough bonds with a low enough interest rate to keep the borrowing and spending going.
Even with pandemic-era spending winding down, the US government ran a $1.38 trillion budget deficit in fiscal 2022. This despite government receipts at near-record levels. Revenues are expected to decline in the months ahead and spending clearly isn’t coming down. That means bigger deficits. And bigger deficits mean more borrowing.
The Federal Reserve enables the US government’s borrowing and spending spree. During the pandemic, the Fed bought trillions in US Treasury bonds. This artificial demand kept bond prices higher than they otherwise would have been and interest rates lower. Without the Fed’s big fat thumb on the bond market, all of the borrowing would have driven interest rates to unsustainable levels.
But in order to fight inflation, the Fed has to shrink its balance sheet. That means it is no longer buying bonds. This is a huge problem for the US Treasury as it tries to find willing buyers for its debt.
On the other side of the equation, the Fed pays for bonds with money it creates out of thin air and the banks inject that new money into the economy. That is, by definition, inflation.
The question is how will the government finance these massive deficits that will only get bigger with this new spending bill when the Fed is on the sideline?
The answer is it won’t. Not in over the long term. If the Fed doesn’t go back to quantitative easing (bond buying), interest rates will rise much higher and crush the federal government under interest payments.
In fact, the US government is already having trouble with rising interest rates.
In fiscal 2022, the US Treasury forked out $475 billion just to fund the government’s interest payments. That was up about 30% from fiscal 2021. Interest expense already ranks as the sixth largest budget expense category, about $250 billion below Medicare.
According to the Congressional Budget Office, interest expense is about to balloon. It projects interest payments will triple from nearly $400 billion in fiscal 2022 to $1.2 trillion in 2032. And it’s worse than that. The CBO made this estimate in May. Interest rates are already higher than those used in its analysis.
If interest rates remain elevated or continue rising, interest expenses could climb rapidly into the top three federal expenses. (You can read a more in-depth analysis of the national debt HERE.)
The bottom line is the Fed can’t slay inflation while the federal government is spending itself deeper and deeper into debt. Given that there is no end in sight to the spending, we should expect inflation to remain with us for the indefinite future.
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