By Kevin McNabola
Orange Board of Finance
Kevin McNabola
In June the Federal Reserve raised its target interest rate by 75 basis points, the largest increase since 1994. To make matters worse, retail sales unexpectedly fell and gross domestic product for the second quarter is projected to be flat to slightly negative.
With the first quarter coming in at –0.5 percent, this begs the question of whether we are in a recession right now. The true definition of a recession is two consecutive quarters of negative growth. However, all the signs indicate that we are about as close to a recession now as we have been since 2008.
The latest statement from the Federal Reserve is mind-blowing. A press release states, “Overall economic activity appears to have picked up after edging down in the first quarter.”
Really? The Federal Reserve totally miscalculated inflation early on, calling inflation transitory in nature, meaning that inflation will be short-lived due to supply chains being negatively impacted by the pandemic. But the pandemic is only one driver of the current inflation equation.
There are three leading factors which are driving the current historic 40-year high 8.6 percent inflation rate: excessive levels of debt, monetary stimulus and rising energy prices.
The US is more indebted today than it has ever been historically, with a total non-financial debt/GDP ratio of nearly 300 percent, including government, corporate and consumer debt. This excessive debt is a financial time bomb that, left to its own devices, could result in a deflationary bust involving widespread defaults, stock market and housing market crashes and bank failures.
As a result of this genuine and worrisome threat, policymakers are not leaving anything to chance. It has become increasingly clear that a high level of inflation is becoming a policy goal to alleviate indebtedness and the risk of deflationary bust that comes with excessive debt.
There are good reasons to assume that this was the policy goal in 2011, too, only policymakers failed at their goal. The US debt/GDP ratio has not fallen but has, in fact, risen by about 50 percent of GDP since then. Today’s excessive level of debt, then, is not a driver of inflation per se; however, it is a driver of the government policies that cause inflation.
The Fed hasn’t mentioned that the M2 money supply (an indicator of money supply and future inflation) increased by 40 percent within the past year. The Fed also purchased nearly two-thirds of the bonds sold by President Joe Biden’s $2 trillion rescue package, which is a major factor in causing the inflation we experience today. In addition, the Fed has financed spending with the purchase of over $4 trillion of US Treasury bonds and other financial assets since March 2020.
These gargantuan stimuli have been accompanied by the increasing popularity of modern monetary theory among economists, which argues that the only limit to fiscal spending is excessive inflation. With inflation being the only limitation on deficit spending, it is no wonder that policymakers are describing the current inflationary impulse as transitory.
The third factor is rising energy prices. Look back to 2008; the world experienced record-high oil prices, and the profits of the energy industry expanded greatly. With rising profits came an extraordinary level of investment in future oil production. The resulting oil boom of the 2010s and a rapid increase in global oil production dampened energy prices.
In 2020, record low oil prices driven by the pandemic led to record losses among energy companies and significantly reduced capital expenditures in energy exploration projects. Due to lack of investment and fewer new discoveries, supply growth across the world is limited and outright supply declines are already taking effect.
Although supply will likely be tight given aggressive policymaker plans to invest in infrastructure, demand for oil and other commodities should remain robust, even assuming considerable growth in electrification in transportation. With constrained supply and increasing demand, energy prices should continue to rise in the coming years, putting upward pressure on costs across a wide range of goods and services, including food supplies (while also enabling the rise of alternative modes of transportation which are more energy efficient).
These three inflationary factors will undoubtedly force the Federal Reserve to raise its target rate a full percentage point every meeting from here on out, until the actual inflation rate starts coming down significantly.
Connecticut has already started to feel the impacts, with an additional tax of 9 cents per gallon on diesel fuel that begins on July 1, which will most certainly have a negative ripple effect on small businesses and consumers.
This increase in diesel taxes could not have come at a worse time. Inevitably, it essentially means that the cost of goods and services, apparel and food are going to increase as well across Connecticut for the next six to 12 months. Higher gas prices will ultimately siphon off discretionary income and consumer spending, ultimately leading to a hard landing for the economy in the near future.
Kevin McNabola is a member of the Orange Board of Finance and finance director for the town of Meriden.