Higher interest rates, inflation and the new economic and political order
The world has changed significantly over the last three years. Things that had been constant for decades were upended in a very short time. The pandemic was the lead cause of almost all of those changes, but those changes are continuing long after it has ended. Things such as remote work that were initially seen as a public health necessity have now become widespread and routine. It’s not the first time a major world event has led to long lasting changes, but it is the first time it has happened in most of our lifetimes.
Because the world we’re in now is new in so many ways, predicting where things are headed has been a near impossible task. That is something I have written about before, particularly when it comes to the economy. This piece in the New York Times gives a quick overview of the two major macroeconomic forecasting errors that have been made since 2021. The first wrong prediction was that inflation would be transitory and go away on its own. The second wrong prediction was that bringing inflation down would require a recession.
The first prediction has definitively been proven wrong. The second prediction has not yet been proven wrong, but has not been looking good lately. Predictions of a recession have been widespread ever since inflation surged in 2021 and 2022. At the beginning of this year, a solid majority of economists polled predicted a recession by year’s end. In October of last year, a model created by Bloomberg economists said there was a 100% chance of a recession within a year.
With the year winding down, not only have we not had a recession, the economy grew at 4.9% during the July through September period. Inflation is still above the Fed’s 2% target, but is down substantially from its peak of a little more than 9% in the summer of 2022. Had most anyone with any economic expertise been told two years ago that inflation would go from 9% to less than 4% within a year, they almost certainly would have said unemployment would go up, too. That would have been wrong. Unemployment is essentially the same as it was when the Fed began raising interest rates in March of 2022.
This is an economy unlike anything we’ve ever lived through. Models that rely on past experiences are going to be highly unreliable in predicting where things are headed. I don’t think there is anything wrong with looking at past experiences. What I do have a problem with is looking at past experiences and declaring that because things have happened historically that means they will happen again. Historically, we don’t have pandemics that upend the entire world economy.
The Times piece tries to explain why forecasts of both inflation and growth were wrong. In the case of inflation, consumers had accumulated tons of savings during the pandemic. Traditional economic models didn’t account for the huge increase in savings that happened despite unemployment surging in 2020. When life was sharply limited by social distancing and other measures, many areas of the economy were effectively frozen. Money that normally would have been spent on services was either saved or spent on goods.
While consumers spent much less than usual, the federal government did the opposite. Between March of 2020 and 2021, the federal government spent more than $4 trillion on economic aid of all sorts. That compensated for the collapse in demand from consumers. Had it not been for the massive amount of aid provided, we would have had another depression.
One downside to all that spending by the government and accumulated savings by consumers was that demand was much higher than supply in many areas. Once the economy reopened, demand instantly surged, but supply was far behind. Supply chain issues were a huge deal in 2021 and 2022 partly because of high demand. The economy as a whole was unable to produce the amount of goods that were in demand and so the limited amount that could be produced had to be allocated somehow. That is where price increases came in.
While inflation started off with goods, it spread to services and has now affected most everything. Inflation is not just a problem in the US. It is and has been a global phenomenon. I’m not aware of any country that data exists for where it hasn’t been a problem. While it has been bad in the US, in many other countries it has been much worse. To give an extreme example, in Argentina, it has been more than 100%.
Most other countries, especially developed countries, haven’t had it anywhere near as bad as that. Still, inflation has been a big problem. Incumbent governments are struggling around the world because of it, regardless of their ideological orientation. Elections held since the pandemic have often seen incumbent governments tossed out. Examples of that include New Zealand (left-wing government lost), Australia (right-wing government lost) and Poland (right-wing government lost). Examples of countries with incumbent governments that are very unpopular or struggling include Canada (left-wing), Germany (center), Italy (right-wing), UK (right-wing) and France (center).[i]
In the case of the US, Biden has been unpopular for two years now. There have been plenty of takes as to why that is, almost all of which are completely wrong. The simple, boring truth of it is that people are unhappy about the inflation of the last two years. How much Biden’s stimulus package passed in March 2021 is responsible for it has been the subject of plenty of debate, but no serious person has argued that inflation wouldn’t have been a problem without it.
I don’t blame Biden for what has happened with inflation. I think he made the right call in going big. While it boosted demand, which boosted inflation, it also boosted growth. Much of the money it allocated has been spent, but state and local governments still have plenty of money to spend. That has probably played a role in why growth has remained strong despite higher interest rates. Without the stimulus package, inflation might be lower, but growth would probably be lower. People hate inflation, but they hate unemployment, too.
Making matters more frustrating is that people don’t just hate inflation, they hate what it takes to bring it down. Interest rates have gone up sharply since March of 2022. That has not yet caused consumers to cut back spending, but it has made some things much more expensive. Housing is the most notable sector that has been affected by it. I think a lot of the dissatisfaction that people have with the economy now could be a reflection of that.
The unfortunate reality is there is no universe where inflation wouldn’t have been a problem in the US or most anywhere. The world economy was essentially frozen for more than a year. Governments around the world poured in trillions of dollars to keep their economies from collapsing and were highly successful at it. Supply and demand were way out of whack and there was no way to avoid that even if every policy decision had been perfect.
While it was a bad thing that predictions of inflation being transitory were wrong, it has been a good thing that predictions of a recession have been wrong so far. Why those predictions have been wrong is subject to debate, but there is one explanation I find very convincing, which I wrote about recently. The Times piece briefly discusses why growth has remained solid, but mostly just mentions that fiscal stimulus measures are still having an effect. That’s right, but not the full story with respect to fiscal policy.
It’s not just left over money from stimulus measures. From 2021-2022, three big fiscal spending packages were passed that were not economic stimulus measures per se. Those were the infrastructure bill, the CHIPS Act and the Inflation Reduction Act. All of them ensure that federal spending will continue to boost demand in some areas for the foreseeable future.
Economic and political ramifications of higher interest rates
The last section of the Times piece talks about what a “normal” economy would look like. I have written before about how I think the word “normal” should be thought of in the context of the economy. The short answer is I don’t like that description. I don’t think there is such a thing as a “normal” economy.
What we have are economic eras where different things are going on. Much of what was thought of as “normal” since the financial crisis in 2008 was an offshoot of interest rates being very low. There was nothing “normal” about any of that. It was all a product of bigger forces at play.
After 2008, demand was extremely low. Fiscal stimulus was inadequate and the private sector was suffering from a debt overhang. To translate the latter into English, consumers and businesses had accumulated large amounts of debt leading up to the collapse of the housing market. When the economy fell off a cliff, many of them were still on the hook for what they owed and so they spent years paying it back. Paying back debt took up most of what they had to spend, which meant there was less spending on everything else, resulting in much lower overall demand.
In an effort to boost demand, the Fed lowered interest rates to zero and kept them there for years. With interest rates at zero, borrowing costs for everyone were very low. That made investing in bonds less attractive and so more money went into equities of all sorts. That was what drove the so-called “sharing economy” (Uber, Lyft, Airbnb, etc.) in the 2010s. Silicon Valley thrived during that time, but, since interest rates started going up, has had a downturn.
The raising of interest rates has been sharp and how high they will stay and for how long is subject to plenty of debate. I have no idea what the answer to either of those questions is. There seems to be little to no consensus about it as far as I can tell. What does seem to be agreed on is the days of zero interest rates are over. That sounds right to me. Interest rates being at zero is something that is only done in response to a crisis such as a deep recession or a pandemic.
Higher interest rates will have a large impact across the economy. As is always the case with sweeping phenomena, it won’t be entirely good or bad. There will be areas of the economy that do well and areas that struggle. I’m not going to make any predictions as to who will be in either camp because I don’t have any idea.
When it comes to political and policy implications, however, higher interest rates’ impact becomes much clearer. These could be famous last words, but overall I think it will be a good thing. Namely, it will bring back the old debate over taxes and spending that has been on a hiatus for most of this century. Dick Cheney allegedly said Reagan proved deficits don’t matter. That line is frequently criticized, but it does have some validity. When interest rates are low, borrowing costs for the government are minimal. That means running deficits is cheap so taxes can be cut while spending is raised. That was the approach both Republican presidents this century took.
With low interest rates, the tradeoff between raising/cutting taxes and spending is effectively gone. As a committed Democrat, I think that’s mostly been bad because it has benefitted Republicans a lot more. Republicans want to cut spending on all kinds of programs, but never go through with it because it’s toxic. What they do go through with is the only thing they know how to do anymore and that is cut taxes.
When the tradeoff between taxes and spending was absent, they could get away with doing that. With interest rates being higher, that’s no longer the case. It wasn’t long ago when the deficit had an effect on interest rates. It was an issue in the 1992 presidential campaign and the subject of a key moment in one of the debates. When interest rates are high, rising deficits increase borrowing costs, which has effects on peoples’ lives in real ways. When interest rates are low or zero, arguments about the deficit are abstract, but when they’re high they become concrete. The world we were in before 2022 was the former, but the world we’re in now is the latter.
Higher interest rates plus the risk of inflation will bring back the tradeoff between taxes and spending. It will no longer be an option to raise spending while also cutting taxes. That will pose problems for both parties, but it will be a much bigger problem for Republicans. Their push for more tax cuts will have to be offset by spending cuts, which will affect popular programs and will run afoul of the promise they’ve made since 2016 to not touch entitlements.
Should Republicans win the White House and Congress in 2024, they will be confronted with that dilemma. They got away with cutting taxes and raising spending in 2001-2006 and 2017-2018, but that was when interest rates were low and inflation wasn’t a concern. Interest rates may not be as high in 2025 as they are now, but they will almost certainly be much higher than they were in 2017-2018. The worry about sparking a surge in inflation will also be there.
If Republicans in 2025 decide to pursue tax cuts, which Trump and his team have said they want to do, they will almost certainly have to find a way to offset it. That will force them to decide how much they really want to do it. If they go through with it, they will have to touch entitlements, which will be guaranteed to provoke a major backlash from voters. Alternatively, and politically much smarter, they will have to abandon their sacred cow of cutting taxes and actually try to do things that help working-class people. The problem is very few Republicans in Congress have any interest in that. That’s a consequence of years of elevating the party's entertainment wing while hollowing out its governing and policymaking wing.
To be sure, Democrats will be confronted with challenges, too. Many Democrats want to see a big expansion of the safety net financed entirely by taxing the top 1% and corporations. That's not going to fly. The good news for Democrats is that there is plenty of money to be raised by taxing the highest earners and corporations so they will have much more freedom to do things than Republicans will.
Predictions of a fiscal crisis have been wrong time and again for many years, but they only have to be right once. Because of higher interest rates, deficits do matter again. Sooner or later, the country’s bad fiscal trajectory will have to be addressed. There will almost certainly be a combination of spending cuts and tax increases as just doing the former is awful and toxic while just doing the latter is bad for growth and mathematically very difficult. The real debate will be over how much of whatever is agreed to consists of spending cuts versus tax increases.
Whenever the fiscal trajectory is addressed, my guess is the politics of it will be much harder for Republicans than Democrats. Republicans have made gains in working-class areas by defusing some fiscal issues that hurt them there before. When the tradeoff between taxes and spending returns, how will they respond? Democrats will have an easy time responding. They will say tax the wealthy. That’s hardly sufficient, but it’s something and is very popular. Republicans aren’t going to advocate for tax increases because their donors will revolt, but what will they do on spending? If they revert back to Paul Ryanism that will erode the gains they made in working-class areas and likely scramble current party coalitions to their detriment.
That all might seem far off in the future and maybe it is, but probably not. Right now, large, unpaid for spending increases and/or tax cuts would be very problematic because of high interest rates and the risk of a surge in inflation. That will probably still be the case in 2025 and beyond. The world so many of us got used to during most of this century is over. Zero interest rates aren’t coming back any time soon. The world of tradeoffs is back and we’re all going to have to adapt to it.
[i] Canada and the UK will have elections within the next year or so and the incumbent parties are likely to do poorly.