There’s little doubt among economists that monetary policy—adjusting financial conditions through interest rate changes and other actions—should be a key tool for reducing inflation from its current high level. But the question of how those in charge of government fiscal policy should use their tax and spending tools when inflation is high is a lot trickier, says Harvard economist Karen Dynan.
In an essay published Monday by the Peter G. Peterson Foundation, Dynan offers six guiding principles to help fiscal policymakers make decisions that factor in the complex circumstances shaping current economic conditions, not least the deep impact of the COVID pandemic.
Dynan, professor of the practice of public policy at Harvard Kennedy School and professor of the practice of economics in the Harvard University Department of Economics, contributed one of 11 essays by prominent U.S. economists published as a package by the Peterson Foundation, a nonpartisan foundation focused on America's fiscal challenges. The goal is to aid policymakers who face difficult choices on inflation, interest rates, and the interplay between fiscal and monetary policy.
Dynan brings more than a scholar’s eye to these challenges. She previously served as assistant secretary for economic policy and chief economist at the U.S. Department of the Treasury from 2014 to 2017, and before that spent 17 years on the staff of the Federal Reserve Board.
Her essay teases out the long-run fiscal challenges facing the economy even before COVID, including a federal budget deficit projected to grow dramatically in coming decades—from nearly 100% of GDP in 2021 to 180% by 2050.
In one example of the complexities facing policymakers, Dynan notes that the effects of higher inflation include more government spending to meet cost-of-living adjustments and for goods and services. But tax revenues also will go up, and as GDP rises over time it could become easier for the government to handle the debt.
Fiscal austerity should not be used as a key lever to bring inflation back to an acceptable level; fiscal policy is not sufficiently nimble to respond quickly, and austerity could hit low-and middle-income people hardest.
Furthermore, the Federal Reserve’s tighter monetary policy could reduce inflation but at the same time slow the economy to the point of a “hard landing,” which Dynan says becomes more likely the longer inflation remains high and the Fed responds by squeezing monetary policy even harder.
One major and unresolved question, she adds, is what happens in the long run to the “real rate of interest”—interest rates adjusted for inflation. Buyers of government debt may become unnerved by the current burst of inflation, particularly if it persists and damages the economy, leading them to demand more compensation for holding government debt in the future. As a result, the real rate of interest could rise in the longer run to an extent that makes government debt less sustainable.
Given the uncertainties of these scenarios, Dynan suggests six principles for fiscal policymakers:
- Fiscal austerity should not be used as a key lever to bring inflation back to an acceptable level; fiscal policy is not sufficiently nimble to respond quickly, and austerity could hit low-and middle-income people hardest.
- Fiscal policymakers should not make the current inflation problem worse by raising overall demand; a good starting point is to keep future changes in fiscal policy budget-neutral.
- Fiscal policies designed to boost the supply side of the economy aren’t likely to curb inflation quickly.
- Fiscal policy can and should play a role in reducing hardship from inflation among the most vulnerable households.
- The United States faces serious longer-term fiscal challenges even under the best-case inflation outcomes; tax increases and spending cuts will be needed in coming years to put debt on a sustainable path.
- We should fight future demand-driven recessions aggressively with fiscal policy—but we will need to take lessons from the past year on how to do so without triggering high inflation.
Banner image: A page holds copies of the Inflation Reduction Act inside an elevator inside the Capitol, Wednesday, Sept. 7, 2022, in Washington. (AP Photo/Jacquelyn Martin)