MainStreet Macro: Inflation-Tag team

Main Street received good news last week.  Not only did we see a slight cool-down to our national summer heat wave, we learned that inflation dipped, to 8.5 percent over the last 12 months ending in July from 9.1 percent for the same period in June.

The news wasn’t all good. Yes, gas prices are lower. But food prices soared 13.1 percent from a year ago, the highest annual increase since 1979. And at a time when many Main Street residents just want a working air conditioner and a cold drink, both were more expensive in July than last year: Electricity rose by 15.2 percent and beverages by 13.8 percent.

Beyond food and energy prices, what’s known as core inflation remained largely unchanged. This suggests that there’s still a rough road ahead before we see more comfortable price growth, something closer to 3 percent or less instead of 8 percent or more.

Inflation-fighting is typically done in the Federal Reserve’s arena. But in this fight, a new entrant has thrown its hat into the ring – Congress.

On Friday, the House passed the Inflation Reduction Act of 2022, sending it to President Joe Biden’s desk. The massive piece of legislation rekindles an old economic debate over whether and how fiscal spending influences inflation.

To understand whether Congress might or might not have the power to attack inflation, keep in mind three main features of inflation-fighting fiscal policy.

One, the approach

Inflation is commonly described as too many dollars chasing too few goods, which leads to accelerating prices.

In that scenario, there are two primary ways to fight inflation: Reduce the amount of new dollars that Main Street pumps into the economy, or amp up the supply of goods and services that Main Street can spend its dollars on.

The Federal Reserve takes the former approach. By wielding monetary policy in the form of interest rate hikes, the Fed indirectly lowers business and consumer demand by increasing the cost of borrowing. Increased borrowing costs lead to reduced spending and help contain price growth.

Two, the attack

The Fed raises interest rates to temper demand and reduce inflation. Similarly, Congress could use higher taxes to curb spending. The more Main Street and corporations are taxed, the less there is to spend, which can cool inflation.

But like higher interest rates, higher taxes can take a lot of time to have an effect. By the time they do, economic conditions can change dramatically. Solving one problem, inflation, could increase the risk of another recession.

Three, the counter-strike

The Inflation Reduction Act doesn’t increase corporate taxes across the board. Instead, its targeted provisions require corporations to pay a minimum tax rate of 15 percent – an estimated $222 billion in new revenue – to offset new government spending in the bill. It will impose a new tax on stock buybacks, which is expected to raise $74 billion. And it boosts the Internal Revenue Service enforcement budget, with an estimated $124 billion increase in tax collection.

And spending in the bill is directed to areas that could lower costs for millions of consumers. It invests $437 billion toward renewable energy and price controls on prescription drugs.

That new federal spending isn’t likely, or even intended, to lower inflation in the next month or two. Rather, Congress is making investments today that it believes will tame rising energy and health care costs in the future.

My Take

The inflation discussion has moved from how high headline inflation will rise to how long abnormally high inflation will persist.

Even after inflation eventually returns to its pre-pandemic level, the Fed will still struggle to combat a modern driver of inflation, shocks to global supply. Our current supply chain woes are having a more persistent impact on future price growth than they’ve had in the past.

In this future world, the Fed might need a new ally in the ring. But can a monetary-fiscal tag team knock out inflation in the short run? There are several rounds left in this fight before we can deliver a verdict on that. 

What we do know is that government spending and fiscal investments that make the economy more productive are the best defense against higher inflation in the long run.