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To Temper the Effects of Monetary Restraint, We Need Pro-Growth Fiscal Policy

Political pressure is mounting against Federal Reserve Chair Jerome Powell to curb his inflation fight by limiting further interest rate hikes and resuming quantitative easing. But with inflation continuing, it would be a grave mistake for Powell to bend to this political pressure. Instead, Congress and the executive branch should do their part and implement pro-growth fiscal policy to balance the Fed’s necessary monetary restraint. 

Year-over-year inflation as measured by the Consumer Price Index (CPI) now sits at 8.3 percent, the highest rate since the crushing inflation of the 1970s. It’s worth reflecting on how we got here. Inflation is at a 40-year high, in part, because interest rates have been kept artificially low for too long. Loose monetary policy and easy money created the conditions for inflation—too much money chasing too few goods. Government-imposed lockdowns in response to the Covid pandemic also distorted the market, disrupting supply chains. Simultaneously, a reckless fiscal policy that sent cash to consumers, supercharged demand. 

Progressives like Elizabeth Warren have called for the Fed to limit any further rate increases, claiming that “the Fed has no control over the main drivers of rising prices, but the Fed can slow demand by getting a lot of people fired and making families poorer.” Similarly, other leading progressives and pundits have argued that the Fed risks tipping the economy into recession if it continues its rate increases, thereby concluding that the Fed should halt any further increases despite the fact that the inflation problem hasn’t come close to being solved. It would be a critical mistake for Powell to heed these calls. 

Chairman Powell has been right to raise the federal funds rate, a policy lever that increases the cost of borrowing thereby dampening demand and slowing the growth of the money supply. It’s true this monetary restraint could trigger a recession, in part because it exposes the malinvestment that resulted from the Fed’s easy money policies. However,if we want to tackle inflation and avoid a prolonged recession, we should implement both monetary and fiscal tools to cool demand and increase supply. This playbook has worked before. The Reagan administration and the Volcker Federal Reserve successfully tamed inflation and ushered in an era of economic growth and prosperity. By increasing the cost of borrowing and thereby quelling demand, and by cutting taxes and thereby unburdening supply, Reagan and Volcker established the conditions for an economic recovery.

Inflation peaked at 14.8 percent in March 1980. By the time President Reagan took office in January 1981, Federal Reserve chair Paul Volcker had begun his monetary tightening, raising interest rates which peaked at 20 percent in June 1981. This “Volcker shock,” as it was known, sent the country into two consecutive recessions, the first in 1980 and the second running from 1981 to 1982, and saw unemployment nearing eleven percent. 

With political headwinds of 10.8 percent unemployment and a 1.44 percent decline in GDP, Reagan took the helm of the nation at a time of recession, high inflation, rising unemployment, and a Fed undeterred by economic pain. He could have scapegoated Volcker, claiming he raised rates too quickly and needed to pursue a more modest, gentle approach to fighting inflation—a “soft landing,” so to speak. Instead, Reagan recognized that Congress and the executive branch also had a role to play in steering the country out of recession. Pro-growth fiscal policy served as a complement to the monetary tightening. While interest rates rose to curb demand, taxes were cut to spur supply. By doing both in tandem, the economy was brought into balance as demand lowered to meet supply and supply rose to meet demand. 

Reagan implemented two major tax cuts during his two terms. The first was the Economic Recovery Tax Act of 1981, which cut the highest personal income tax rate from 70 percent to 50 percent and the lowest from 14 percent to 11 percent, and decreased the highest capital gains tax rate from 29 percent to 20 percent. The second tax cut was the Tax Reform Act of 1986 in which federal income tax rates were lowered further, the number of tax brackets were reduced, and the top tax rate declined from 50 percent to 28 percent.

Ultimately, Reagan’s fiscal policy worked. Inflation decreased from 14.8 percent in March of 1980 to 3.9 percent in March of 1982. Unemployment fell from a peak of over ten percent to 5.5 percent by the end of the decade. And real growth averaged 3.5 percent over the decade as well. 

This chapter of American economic history provides useful lessons for today’s inflation fight. After initially caving to political pressure and keeping interest rates too low for too long, Powell is now attempting to redeem himself by withstanding pressure to limit future rate increases. But to temper the effects of monetary tightening, avoid a prolonged recession, and ultimately ignite economic prosperity, we need an executive and Congress willing to pursue pro-growth fiscal policy. 

So far the politicians in power seem completely uninterested in doing so. In fact, President Biden regularly muses about inventing new taxes to punish producers for their sins of greedily raising prices. This would be the exact opposite of what is needed: to lower prices for consumers. 

And the taxes the Biden administration has already imposed in its disingenuously named Inflation Reduction Act (IRA) will be economically harmful in the long run. According to the Tax Foundation, “Biden’s tax plan would have a negative effect on the U.S. economy, reducing long-run GDP by 1.62 percent” and shrinking “the capital stock by about 3.75 percent.” And it goes without saying that the IRA will have little to no impact on inflation, actually raising it slightly in its first two years of implementation with estimates from the Penn Wharton Budget Model of its broader inflationary effect “statistically indistinguishable from zero.”

With no sign that those in power will change course, let’s hope a divided Congress can impose some fiscal discipline on the executive. And as the midterms pass and attention turns to the 2024 presidential election, inflation and economic health will likely remain top of mind for candidates and voters. As we enter into the long march of presidential campaign season, it’s worth considering that we may have our Volcker for now, but we need a Reagan.