Francesco Bianchi, Johns Hopkins University Louis J. Maccini Professor of Economics, sits down with Yahoo Finance Live to discuss the Fed's monetary policy, inflation, and government spending.
SEANA SMITH: Fed Chair Jerome Powell has made it clear that the Fed is committed to bringing down inflation, saying he's confident the bank will, quote, "get the job done." But a new paper suggests that the Fed can't fix it alone and could make matters worse with aggressive rate hikes. Joining us now is one of the authors of this paper, Francesco Bianchi, Johns Hopkins University professor of economics.
Professor, it's great to see you. I want to read a quick excerpt here from that paper that you just published. Quote, "Approximately half of the recent increases in inflation has fiscal roots. When inflation has a fiscal nature, monetary policy alone may not provide an effective response." I guess first, why? Why can't the Fed fix it themselves?
FRANCESCO BIANCHI: So when inflation has a fiscal nature, meaning when inflation is in part due to the perception that we might use inflation to partially stabilize spending. We spent a lot during the pandemic. Arguably, that was the right thing to do given where we were in that situation. This probably shifted the perception about what I call the monetary fiscal policy mix going forward.
So this generated inflationary pressure because we expect at least in part, that part of this spending would be stabilized through inflation, as opposed to an increase in taxes down the road. Well, when inflation comes from this perception, simply increasing interest rates is not enough. What you need to do is, in a sense, to change the perception that going forward we might have what we call fiscal inflation.
And the reason why simply increases in interest rates is not enough is because when you increase interest rates, you might be able to push the economy in a recession, pushing the economy in a recession determines further debt accumulation. And if markets, agents expect that this additional increase in debt is also resulting in inflation, you might obtain more inflation in the long run. So what you need to do is, of course, increase interest rates to send a signal that the Fed is committed to low and stable inflation. But on the other hand, you also need to make clear that we have the necessary fiscal adjustments in place to make sure that the fiscal burden is taken care of through tax increases as opposed to inflation increases.
- But is that the job of the Fed?
FRANCESCO BIANCHI: No, of course, it's not the job of the Fed. So the paper discusses a lot that the Fed has one job, that is one of moving interest rates and trying to bring inflation under control. But what we need, on the other hand, is a fiscal framework that is consistent with that goal. So notice that this is a part of an historical analysis that argues that the high inflation of the '70s was ultimately a fiscal phenomenon.
We always talk about the fact that the central bank, the Federal Reserve was so dovish in the '60s and '70s and let inflation go up. But what we show in our analysis is that this was combined with excessive fiscal spending and with lack of clarity of how we were going to finance this excessive spending. And so the Fed can do its side of the job, that is to increase rates and try to bring inflation under control, what we need, on the other hand, is that the fiscal authority essentially does his side of the job, that is to make sure that over the medium run-- it doesn't have to be today-- but over the medium run, spending is under control, taxation is in place to sustain all the programs that we might find interesting as a society.
- I want to talk about another excerpt from this paper, saying quote, "Monetary tightening would actually spur higher inflation and would spark a pernicious fiscal stagflation, with the inflation rate drifting away from the monetary authority's target and with GDP growth slowing down." Could you elaborate on how we'll actually see that play out on what sort of time frame?
FRANCESCO BIANCHI: That's a good question. So what we find in our analysis-- and remember that there is a lot of uncertainty whenever you do statistical work-- when we find-- when we conduct our analysis, we find that there's been an increase in the probability of this event. This probability is still relatively small in the sense that the most likely scenario is still that we will go back to what we call a monetary-led policy. So think about the policies of the '80s and the '90s. But, nevertheless, we find a sizable increase in the risk of entering this regime in which the central bank can lose control of inflation.
And our point is to show that in the moment there is the risk of this scenario and in the moment the Fed has already started going through a different monetary policy cycle-- in other words, the central bank has already started increasing rates very aggressively. You want to definitely remove this risk from the table. What that means, removing this risk from the table, is to send a clear signal that no matter what our policies are going to be over the years ahead, we are-- we know how to fund them. We know how to balance spending with taxation.
- Much of the criticism of the Fed today is about really being behind the curve. So let's just say, in the rearview mirror, they started tightening earlier, would we be in a better place today?
FRANCESCO BIANCHI: Well, that's a great question. And if you read the paper carefully, that's definitely something that we ask in the paper. We basically show that if the Fed that started increasing rates one year earlier, so essentially as soon as we saw the first increases in inflation, but keeping the outlook for the medium run unchanged, we would have seen, actually, only a small gain in terms of reduction in inflation, but a big large-- sorry, a big output loss.
So what that means is that if the Fed had increased rates, without changing the perception about the future fiscal framework, we would have gain very little in terms of inflation and lost a lot in terms of output. And, again, this is really the official, that when inflation is coming from the fiscal side, when inflation is coming from the perception that in the long run we might let inflation run a little bit higher to stabilize debt, there is not much the central bank can do in that case. The central bank really needs, in order to be able to control inflation in the medium run, you really need to-- this inflation target to be consistent with how much we are spending, how much we are going to spend over the years ahead.
- So when we look at some of the things that are outside of the Fed's control, when you match that with what the Fed is trying to do right now, where it's going from here, ideally, if you had the ear of Fed Chair Powell, how would you advise him about going forward from here being that they did start behind the curve?
FRANCESCO BIANCHI: I think the chairman is taking the only path possible given the situation. So I think he's making clear that they are committed to bring inflation down. In a sense, they are trying to send a very strong signal to markets, we are committed to increase rates until we see a tangible reduction in inflation. I think that implicitly, he is also sending a message to policymakers, to the other policymakers, that we need, at the same time, to reduce the stimulus also from the fiscal side. I don't think it can do much more than this, in the sense it's not his job to go to Congress or the president to say what to do.
But I think I believe that some policymakers understand this connection between fiscal spending and inflation. Ultimately, even the way we label the last bill is I think revealing of the fact that policymakers, Congress understands the link between fiscal spending and inflation. So hopefully, there is enough clarity about this link that Congress or policymakers more in general will understand that we need both fiscal policy and the monetary policy on board with the goal of reducing inflation.
- We do. Thank you for joining us on your paper there, Francesco Bianchi. Thank you so much.