Biden and Congress Still Haven’t Made Inflation Central in Budget Matters

Inflation is the economy’s number one problem. The Federal Reserve understands this and has adapted accordingly. Congress and President Biden still haven’t.

To be sure, the massive omnibus spending bill likely to pass Congress doesn’t include big new stimulus. Business tax cuts, an expanded child tax credit and health spending boosts that would have tacked hundreds of billions of dollars onto deficits and elevated inflation pressure in coming years were all dropped.

In that, the bill marks a pivot from the past two years when President Biden routinely signed executive orders and legislation that pumped up deficits and spending.

Yet the bill still raises nondefense, nonemergency spending by 8% and defense spending by 10% next year—above current inflation of about 7%—according to the Committee for a Responsible Federal Budget. So at the margin the bill adds to, rather than subtracts from, demand and inflation pressure. Last year’s equivalent bills together boosted spending about 6%. Emergency spending this year comes to $85 billion, compared with about $15 billion a year ago.

So while both parties and Mr. Biden all acknowledge inflation is the economy’s dominant issue, that reality has yet to penetrate their approach to fiscal policy. In effect, that puts more on the shoulders of the Fed, which is already raising interest rates sharply to combat inflation near the highest levels in 40 years.

Republicans routinely blamed inflation on Mr. Biden’s stimulus programs. Yet they are happy to pump up deficits to cut taxes, such as in 2018. They had, in the past month, pressed to extend some expiring tax cuts for business; they balked when Democrats in return asked to expand the child tax credit. They pushed hard to boost defense spending next year above the inflation rate.

For Mr. Biden, it is more complicated. When he took office in 2021, mainstream economic thinking was still heavily influenced by the decade following the 2007-09 financial crisis, during which inadequate demand kept employment weak, inflation persistently short of the Fed’s 2% target and interest rates near rock bottom. This inverted the usual argument against deficits—that they raised interest rates and crowded out private investment. In 2020, the Fed altered its monetary policy framework in 2020 to emphasize the goal of full employment and a tolerance for inflation exceeding its 2% target.

Progressives welcomed this: It meant they could push their priorities, such as more spending to address the environment and social inequities without having to pay for them. A few embraced “modern monetary theory,” a heterodox school of economics that rejects any connection between deficits and interest rates and advocates borrowing as much as needed to achieve full employment.

Mr. Biden’s economists are orthodox Keynesians, not MMTers. They saw his 2021 $1.9 trillion American Rescue Plan as a down payment on his social agenda that also hurried the economy’s return to health. 

As the economy reopened over the course of 2021 it became clear they had got the problem backward. Demand wasn’t inadequate: it was soaring, stoked by vaccines, economic reopening and monetary and fiscal stimulus. Inadequate supply was the problem: Distorted spending during lockdowns had snarled supply chains while early retirements and the Covid-19 virus had shrunk the labor force. Inflation shot well past the Fed’s 2% target and stayed there.

White House officials argue, with justification, that Mr. Biden’s stimulus gets too much blame for high inflation. Private economists’ models, before and since, suggest it explains at most a very small share of the surge in prices. Inflation in other countries has risen almost as much.

And when inflation proved not to be transitory, the administration pivoted. One White House official said the 2021 stimulus was designed before the nature of the recovery became clear. Policies since then have been made with that realization in mind, he said.

Administration officials have since promoted their own version of supply-side economics as a salve for inflation. They say Mr. Biden’s original “Build Back Better” proposal was a long-term strategy to boost the economy’s productive potential and overcome supply-side obstacles. They point to bills Mr. Biden signed that increase investment in infrastructure, semiconductors and green technology.

But these initiatives don’t deal with today’s inflation problem. The economy is already operating above capacity. So funneling capital and labor toward one sector such as electric cars, semiconductors or infrastructure means taking them away from another. And while some investments, such as in infrastructure, might raise future supply, they first add to current demand for labor, equipment and materials.

In short, Mr. Biden’s agenda is more about reallocating existing supply rather than raising aggregate supply, which is what matters for inflation. Expanding aggregate supply defies easy policy solutions. Mr. Biden has targeted increased child care to boost women’s labor-force participation, but it is unclear where the money will come from or whether it would have the desired effect. Republicans claimed their deficit-financed tax cuts in 2018 would boost investment and long-run growth, but there is little evidence that happened.

Since last year the Fed has pivoted, seeking to reduce excess demand and inflation. Chairman Jerome Powell has said improved supply, such as of labor, would make his job easier, but in the meantime, the Fed’s tools, primarily higher interest-rates, only affect demand.

Some progressives are already criticizing the Fed’s rate hikes. MMT advocates call for regulations or a resolution to the war in Ukraine as alternatives to higher interest rates.

Mr. Biden has fully backed Mr. Powell. But neither he nor Congress are helping the Fed by raising taxes or restraining spending to damp demand. The Inflation Reduction Act enacted last August is projected to reduce future deficits. But its anti-inflation impact is swamped by other laws and Biden’s executive orders such as his cancellation of student debt (currently stayed by the courts) that vastly boost deficits.

Marc Goldwein, senior policy director at the CRFB thinks inflation has changed some legislators’ attitudes. Sen. Joe Manchin (D., W.Va.) was virtually alone when he blocked Build Back Better out of inflation concerns. A bill “that would only lose Joe Manchin a year ago would lose six or seven Democrats in the Senate today,” Mr. Goldwein said.

The political landscape for fiscal policy in the next two years will be different from the last two. When Republicans take control of the House of Representatives, they are unlikely to agree to Mr. Biden’s priorities such as increased spending on child care or child tax credits. Democrats aren’t likely to be any more accommodating of Republicans’ enthusiasm for cutting taxes.

So if fiscal policy makers stop making inflation worse, thank gridlock, not a change of heart.