The current spike in inflation could lead to a recession, according to Professor of Economics Ivan Pongracic.
“We are in a situation that we haven’t been in for a long time,” Pongracic said.
In December, inflation jumped up to a rate of 7% without declining.
Pongracic said the government has been spending an enormous amount of money since the financial crisis of 2008-09.
The COVID-19 pandemic has worsened the situation, he said, with the deficit of the federal government going from $1 trillion to $3 trillion.
“The federal government assumed all sorts of emergency power and started spending as if there was no tomorrow,” he said.
Pongracic said the results of low interest rates include student loans and mortgages.
“Why have the interest rates been so low?” Pongracic said. “We have engaged in this experiment which will be forced to come to an end in a pretty painful way of incredibly expansionary monetary policy and extremely low interest rates for almost 14 years now.”
He said one of the primary causes for this jump in inflation was the Federal Reserve accommodating the federal government by buying about half of the $6 trillion of accrued debt over the course of two years.
“There were insufficient private entities, certainly not foreign central banks and foreign governments, that wanted to buy $3 trillion worth of bonds,” he said.
The federal government relied heavily upon the Federal Reserve, creating an unprecedented level of monetization.
“Different parts of the government are using the power to create money to finance the fiscal operations of the federal government,” Associate Professor of Economics Christopher Martin said. “This is worrisome because it means our budgetary decisions are not having to go through Congress as much. The Federal Reserve’s loose money policies are facilitating the volume of spending that we’re seeing.”
Pongracic said the Federal Reserve began retracting part of this spending in 2017, but now faces the pressure of the legislature due to the effects of the pandemic.
He said the government started handing out stimulus checks to people without forcing them to work, adding to the increase in inflation.
“When you get money in your account, you have less incentive to work,” Associate Professor of Finance Robert Atra said.
Atra said one concern will be as to how the government will pull people back into the workforce.
“The fact that the Federal Reserve is still financing the money will lead to an enormous number of problems,” Pongracic said.
Pongracic said the only solution is for the government to create a “soft landing” by gradually slowing down the economy to slow down inflation.
“The Federal Reserve has to convince people that the inflation rate is going to fall,” Martin said. “They will have to accomplish this by raising interest rates. If they do this too aggressively, they will cause a recession.”
Martin said the Federal Reserve needs to maintain credibility with the people.
“If the central bank sacrifices its independence and loses its credibility, high inflation rates follow, and it’s incredibly difficult to break out of those kinds of high inflation situations because so much of it is psychological,” Pongracic said.
Martin said the less people trust the Federal Reserve, the more aggressive the Federal Reserve needs to act.
“The Federal Reserve also has to ensure its credibility is protected against the legislature,” Pongracic said. “If the Fed continues down this path, it will very likely sacrifice its credibility.”
Pongracic said the only solution is for banks to engage in painful policies with a high chance of plunging the economy into a serious recession.
Another negative outcome is that savers will lose the purchasing power they once possessed. The situation will prevent many of these savers from retiring.
“Inflation is a way of causing a partial default for everyone who owes money,” Martin said. “It is a fraud on those who have saved money. Everyone who has had bonds or cash or something has seen a lot of their savings be eroded.”
High inflation distorts the price system, causing shelves to be full of the wrong items. Businesses in turn end up going bankrupt because these prices have become distorted, Pongracic said.
“You’re not going to be paid back as much as you expected,” Martin said. “It’s a subset of this whole issue of creditors being harmed.”
