If you want to understand taxes, inflation, spending and interest rates, you should know the difference between fiscal policy and monetary policy and the advantages and disadvantages of each.
The emerging problem with inflation and the probable response of hiking interest rates reminds me of watching congressional hearings on the prime rate when I was in grad school studying economics at Georgetown University. It saddened me to watch a businessman testifying and alternately yelling and crying because he couldn’t afford working capital loans any longer. This was a grown man. At that time, the prime rate had peaked to nearly 20%, and since most bank loans are prime +2, he was probably paying at least 22% interest on his loans. With tears streaming down his fleshy face, he implored congress to do something about it. They couldn’t, of course, because a reduction in interest rates only comes from the Federal Reserve.
I empathized with that guy. I was going to grad school on a fellowship, but had to take out school loans to pay for my very expensive Washington D.C. living expenses. My super-duper low interest rate school loan was something like ten or twelve percent. I have credit cards today with a lower rate than that.
Back to present day. It drives me crazy when I see people complaining about inflation without even understanding where inflation comes from and how to combat it. Like the guy mentioned above, many people confuse monetary policy and fiscal policy, what they do, how they work, and who enacts them. I’m going to explain that. For you. And me. So I don’t have to be annoyed.
What is it? Monetary Policy consists of a set of tools that any nation’s central bank has available to promote sustainable economic growth by making key decisions about interest rates and controlling the overall supply of money that is available to the nation’s banks, its consumers, and its businesses.
Who’s in charge? Monetary Policy in the U.S. is enacted by the Federal Reserve System, or the FED for short. It is not, I repeat not, implemented by Congress.
What are the tools? The main tools are the targeted Effective Federal Funds Rate (EFFR) achieved by lowering or raising the money supply and the Discount Rate. The EFFR is the rate that commercial banks charge between themselves for overnight loans. Besides the EFFR, the Federal Reserve also sets the Discount Rate, which is the interest rate the FED charges banks that borrow from it directly.
How does it work? When the interest rates increase, banks pass that increase right along to you. As I write this, the Discount Rate is .25% which is, of course, ridiculously low. It was a bit higher in 2019 at 2.42%, but then the pandemic happened and the resultant recessionary blip. So the rate was lowered again to help generate growth. The FOMC (Federal Open Market Committee – the policy making arm of the FED) meets every six weeks for eight yearly scheduled meeting, with some emergency meetings in between.
Logically, when interest rates decrease, it becomes cheaper for banks, people and businesses to borrow money. Ostensibly they use the cheaper money to invest in expansion with businesses producing more products and hiring more people. People also buy more products, which leads to more growth and so on. If the economy heats up too quickly (like now), inflation can ensue.
Conversely, if interest rates are raised, it costs businesses more to operate. People spend less money because their credit card rates increase and in theory, the prices of products should go down.
If there is inflation, like there is now, raising interest rates can help abate it. Why? Because higher interest rates make it more expensive to make things. As such, people will buy less. When people start buying less, the supply of products will go up. When the supply goes up, the price goes down. I know, it sounds convoluted, but it makes sense when you think about it.
What are the advantages? The main advantage of Monetary Policy is that it is fast, both in the ability to enact it (it’s just the FED after all and not a bunch of bickering politicians) and the speedy effect it has on the economy.
There is also the multiplier effect which magnifies the pumping of more money into the economy. You can learn more about that in a previous article I wrote: The Multiplier Effect & the Case for Continuing a $1,200 Monthly Check.
What are the disadvantages? The main problem with Monetary Policy is that the FED is limited by how low they can go with rates. It’s hard to get much lower than .25%. Although some countries have actually instituted a negative rate where they pay you to borrow money, but that’s another story for another day.
What is it? Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth.
Fiscal policy is often contrasted with monetary policy, which is enacted by central bankers and not elected government officials.
Who’s in charge? Unfortunately, the United States Congress and the President. Why unfortunately you may ask? Because it can take months and months (if ever) to get a law passed. Both the House of Representatives and the Senate have to pass a bill that the President signs into law or may even veto.
What are the tools? The main tools are taxes and spending.
How does it work? If the economy is in a recession, the government spending money helps boost it. Why? Private businesses can be hired by the government to build bridges, pave roads and make missiles. This improves GDP and increases tax revenues because those businesses hire more people and buy more things. And the people that are hired buy more things. There is a multiplier effect here as well.
Likewise, cutting taxes can stimulate a reinvestment of those formerly paid taxes into expanding growth. Increasing taxes will have the opposite effect.
What are the advantages? Unlike with interest rates, there is no limit, really, to how much money our government can spend and how high or low they can raise taxes.
What are the disadvantages? It is slow. It takes a long time to pass a bill and nowadays can usually only be successful if one party controls both the Congressional and Presidential offices.
Also, if taxes are cut or spending is increased, our National Debt goes up. When fiscal spending or stimulus increases, it can often lead to higher prices. Logically, this is because there is more demand for raw materials and products so the providers of these materials can raise prices.
Some would argue that reducing taxes will increase tax revenue and reduce the debt levels because the companies and people will have more money to invest and spend. But that hasn’t proven to be the case, at least in the last decade. I calculated that and reported my findings in my article, “Is There a Relationship Between Tax Cuts and Tax Revenue.”
Recently, the best way to stimulate the economy has been through Fiscal Policy for the simple reason that the interest rates have already been so low. The recently signed law, Infrastructure Investment and Jobs Act, is a huge Fiscal Policy stimulus package. Let’s see how that does. Tax cuts haven’t worked well either because the top earners who received most of the cuts haven’t really invested and spent like we had hoped. Even corporations that received the tax cuts were stymied by the pandemic and other things such as the recession (demand problems), supply chain issues, and labor issues.
My recommendation to combat the current inflation is to raise taxes a smidgen for corporations and the highest earning individuals. Use it to pay off some of our debt. Don’t spend any more money. Raise the interest rates a very small amount, maybe just by a quarter or half percentage rate. And promote more immigration which will help keep labor costs at bay.