How To Escape A Stagflationary Quagmire

What happens when the FERAL Reserve uses raising interest rates in an attempt to quash inflation?  You guessed it:  STAGFLATION. That is, a combination of economic stagnation (or even recession, if they keep raising it "until something breaks") and persistently high inflation.  But if the only tool that have is a hammer, everything looks like a nail to them.  And a quagmire thus results when tight monetary policy is kept in place well beyond its (very short) shelf life.

Contrary to Milton Friedman, the godfather of neoliberalism (who literally coined the term "neoliberalism" himself, along with the term "stagflation"), who claimed that "inflation is always and everywhere a monetary phenomenon", it is more accurately described as being (almost) always and everywhere a supply-side problem of goods and services, as Rodger Malcolm Mitchell notes.  And the only way to cure it is to cure the shortages, which counterintuitively often requires increasing (and better targeting) federal spending to incentivize production of scarce goods and services, especially energy.  There is clearly an extremely strong correlation (almost perfect, in fact) between energy prices (especially oil) and the general price level (CPI) of goods and services overall.  While there is, contrary to popular opinion, very little to no correlation between inflation and federal deficit spending, or even the general money supply itself.  (The general money supply consists of deficit spending of new money into existence plus banks lending new money into existence, though the latter is of course inflationary albeit only due to interest.)

(And let's not forget greedflation as well!)

At best, as a "break glass in case of emergency" measure, raising interest rates, especially to above the inflation rate, has a weak, very short-term benefit on fighting inflation, followed by a longer-term exacerbation and prolonging of inflation that seems to be unrelated but is in fact caused by it.  After all, hiking interest rates is effectively a blunt and regressive tax that increases costs across the board, which are then passed onto the consumer in the form of...higher prices.  And so on.  That is, MORE INFLATION, in a vicious cycle like a yo-yo.  The "cure" is in fact far worse than the disease, like applying leeches to cure anemia, as Mitchell would put it.

The plandemic-induced supply-chain issues have been resolved, and even the global geopolitical issues would should by now have less effect in the domestic oil and gas powerhouse that is the USA.  Oil and gas prices are now down significantly stateside.  The money supply and federal spending have shrank since then as well.  And yet inflation, though much lower than its 9% peak in 2022, remains stubbornly above than 3% today.  Could it be that keeping interest rates well above the current inflation rate is actually not only part of the problem, but now THE problem?

BINGO.  So the FERAL Reserve would be wise to end Quantitative Tightening and cut interest rates yesterday from the current 5.25% to 3%, then to below 3% very shortly thereafter (within days or weeks).  Then when inflation falls, cut it again to below the new inflation rate, and so on. All the way to zero if necessary.  Failing that, the only thing that would end this quagmire is a severe enough recession to kill demand across the board, which will clearly do more harm than good.  History certainly bears that out.

(It explains not only today's quagmire, but also the 1970s and 1980s in the USA and a fortiori in Canada.  And it even at least partially explains the phenomenon of "chronic inflation" in various Latin American countries in the 1990s and beyond.)

Then, Congress must increase, not decrease, federal spending to cure the stagnation part, which is the other half of the stagflation.  Yesterday. 

And while we are at it, we should also phase out the scam known as "fractional reserve banking" (or more accurately, "fractional capital lending") by increasing the reserve requirement for private banks from the current 0% to 10% immediately, as it was before March 15, 2020, then very gradually raising it all the way to 100% over a number of years.  (The only reason to do it gradually is to prevent markets from suddenly seizing up and causing a financial crisis.)  And also either break up, nationalize, or tax heavily any banks that are "too big to fail" as well.

So what are we waiting for?

P.S.  This argument does NOT apply to "creeping inflation" (i.e. consistently below 3%), as that level of inflation is easily controlled and adjusted for, promotes economic growth, and is actually beneficial on balance.  Such low to moderate inflation is far better tolerated than risking even a small amount of deflation (negative inflation), which, at best, is VERY difficult to control and can all too easily become a vicious cycle and downward spiral into a full-blown depression or long-term "stagpression".  In contrast, inflation only becomes net harmful on balance when it greatly exceeds 3%.  Again, history bears this out.

Interest Rates: A Razor-Sharp, Double-Edged Sword

After debunking the Big Lie of Economics (namely, that federal taxes actually pay for federal spending and that the federal government can somehow run short of dollars) in our previous post, the question of inflation and how to control it remains.  Most economists (including Rodger Malcolm Mitchell) believe that raising interest rates is the best way to do control inflation, while others (mainly in the Modern Monetary Theory (MMT) school of economics, along with Ellen Brown) believe that doing so is practically blasphemy and will only make things worse, relying instead on taxes of various kinds (if anything at all) to control it, albeit crudely.  So which is it?

Well, it seems that the answer is a lot more nuanced than either side likes to believe.  For starters, there are at least two different kinds of inflation: 1) cost-push inflation, and 2) demand-pull inflation.  Sometimes both types occur together almost equally, other times one clearly outweighs or excludes the other.  And whether raising interest rates is helpful or harmful depends on exactly which kind of inflation one is trying to fight.

For cost-push inflation, which is caused by rising production costs resulting from things like higher fuel prices, taxes, or borrowing costs on businesses that get passed onto consumers.  And raising interest rates will only make that kind of inflation worse by increasing borrowing costs for businesses even higher still.  Doing so is like fighting fire with gasoline, and should generally be avoided like the plague.

For demand-pull inflation, which is caused by demand for goods and services outstripping supply for same, on the other hand, raising interest rates is highly effective at preventing and curing such inflation.  If interest rates are (artificially) coupled to money supply, raising the former will effectively shrink the latter, which is of course disinflationary or deflationary.  But even more importantly, whether they are coupled to the money supply or not, raising interest rates also increases the demand for dollars by increasing the reward for holding them.  Remember, as Rodger Mitchell explains, Value = Demand/Supply, and Demand = Reward/Risk, where inflation and default are the risks and interest is the reward.

(Since the risk of default is by definition zero for a Monetarily Sovereign government that consistently acts like it and is not foolish enough to borrow money denominated in a foreign currency, that leaves only inflation vs. interest.  And the net reward is given by:  Interest Rate - Inflation Rate = Real Cost of Money.)

Note too that interest rates can have both types effects, but which one outweighs the other depends on the type of inflation as well as the general condition of the overall economy.  At the same time, the effects of raising and lowering interest rates need not be symmetrical, since lowering interest rates to stimulate the economy often amounts to "pushing on a string" in terms of effectiveness.  Especially since interest on Treasury securities is literally new money that is pumped into the economy, and lowering rates will reduce that money accordingly.  True, there is in fact a positive correlation between the effective Fed Funds Rate and the CPI inflation rate, but that is as much of a chicken-and-egg problem as anything, given that the two types of inflation are both measured the same way, and that the FERAL Reserve usually raises rates in response to or in anticipation of inflation.  (For all their faults, they have generally succeeded in keeping inflation more or less under control at least since the post-gold standard era.)

But how exactly does one distininguish which type of inflation predominates at a given time, and thus whether to raise or lower interest rates?  Usually it is fairly simple.  When the velocity of money (the rate at which money circulates through the economy) is going "too fast for conditions" relative to the economy, that is a fairly strong indicator that demand-pull inflation predominates and that interest rates ought to be raised, even if there is some cost-push inflation mixed into the overall inflation rate.  But if the velocity of money is sluggish, raising rates will likely be counterproductive, at least in the absence of massive deficit spending (i.e. new money creation).

Because regardless of whether or not there is any link at all between interest rates and the actual supply of money, raising rates (especially when raised higher than the inflation rate) will always slow down the velocity of money, ceteris paribus.  Likewise, cutting interest rates accelerates the velocity of money at least somewhat, even if that alone doesn't always stimulate the economy enough in practice.

So what about taxes, then?  In theory, raising taxes and/or cutting government spending should also control inflation by effectively shrinking the money supply.  Remember, since the federal government is Monetarily Sovereign, any tax revenue they raise is effectively destroyed in practice (just like how all deficit spending effectively creates money out of thin air).  But this is a very crude way to do it, and is too slow and political to be particularly useful.  That said, having some level of federal taxation can indeed act as an "automatic stabilizer" even with no changes to the tax code, since when the economy overheats, the velocity of money is high and thus more tax revenue is removed from the economy, while the reverse is true during recessions when the the velocity of money is slower.  That is especially true for the idea of the Universal Exchange Tax, since it specifically taxes the movement of money, but can be true for all taxes.  But interest rate control is ultimately a superior method--as long as the inflation in question is the demand-pull variety resulting from an excessive money supply and/or velocity of money.  And knowing that, there is no good reason why a Monetarily Sovereign government should be shy about creating enough money to fulfill any of its ambitions that benefit the the bottom 99%.

The best, of course, is when interest is NOT coupled to the creation of money.  But until they end the charade and implement Overt Congressional Funding instead, and also fully nationalize the FERAL Reserve, the best way to fight stagflation is to raise interest rates (to fight inflation) while also increasing deficit spending (to fight stagnation), effectively decoupling the two for the time being.  And to fight high inflation in an overheating economy, raise interest rates first with no changes to deficit spending, and if that doesn't work, then reduce deficit spending.  But don't keep interest rates too high for too long--eventually they need to be cut to avoid doing more harm than good to the economy.  And note also that there is no historical correlation between deficit spending and inflation, at least not during peacetime and post-gold standard.  Only during truly major wars has there been any sort of correlation between the two, given how wars tend to create shortages of goods and services.

Wait, what?  That's right, there has been no correlation between federal deficit spending (i.e. money creation) and inflation in recent decades, meaning that any relationship between the money supply per se and inflation is a very tenuous one.  Let that sink in for a moment.  So we are nowhere near the point where increasing the money supply poses any risk of runaway inflation.  And even if we were, we know precisely how to prevent and cure it.

In other words, it looks like both Rodger Mitchell and Ellen Brown are both correct to one degree or another.  But what about what the FERAL Reserve is doing right now, raising interest rates (and implementing Quantitative Tightening) in the midst of historically high deficit spending?  Well, seeing as how inflation is still low and currently dominated by oil prices and the Trump tariffs that are just beginning to bite, it is safe to say that cost-push inflation, not demand-pull inflation, thus predominates now and in the near future, and thus raising interest rates any further now is probably not the wisest idea.  Especially given that, as Ellen Brown notes, the banksters have currently set a minefield of trigger points for variable-rate loans and mortgages, that will be set off if the Fed Funds Rate goes up much higher.  And these oligarchs thus stand to pull off one of the greatest wealth transfers in history, from the bottom 99% to the top 1% and especially the top 0.01% (i.e. to the oligarchs themselves).

Bottom line:  While taxes are more of a blunt instrument when used to control inflation, interest rates are essentially a razor-sharp, double-edged sword, one that we need to be very careful about using willy-nilly.  Don't say we didn't warn you.