WASHINGTON, December 15, 2016 — For the second time in a year, the Federal Reserve’s Open Market Committee (FOMC) has raised interest rates on overnight funds by 0.25 percent, after keeping them near zero for almost eight years. Beginning in January 2017, the new target interest rate band for these funds will ratchet upward from the current 0.25-0.50 percent to a range of 0.50-0.75 percent.
Since 2016 will be the eleventh consecutive year of US economic growth at less than 3 percent, the Fed’s current rate increase isn’t a reaction to rapid growth. Rather, the Fed’s desire to cool the economy results from a concern about potential inflation, especially considering the potential impact of President-elect Trump’s expected economic policies.
There are ways to achieve high growth without inflation.
The Fed reasons that the extraordinarily rapid growth in the money supply—which resulted from the three quantitative easing (QE) moves the Fed undertook since the beginning of the Great Recession in 2008—will eventually result in high inflation. That, coupled with Trump’s expected policies, required Fed Chair Janet Yellen to act and to further indicate that an additional three rate increases may take place in 2017.
The Fed’s higher rates are designed to reduce demand in the economy, especially for big-ticket items like cars and houses, which are purchased almost entirely with borrowed money. The problem is that by reducing demand, the Fed will tend to slow, not increase growth. Trump is trying to stimulate, not retard, economic growth.
Can high growth be achieved while keeping inflation low?
Although there are competing theories regarding why we have inflation and what can be done to treat it, it all really comes down to one simple fact: Prices rise because at current price levels, most customers are willing to purchase an amount that is greater than business is willing or able to produce.
Many economists say this is a result of too much demand arising from too much money in circulation. At least that is the most popular belief at present. Reducing the growth of the money supply and raising interest rates, they reason, will reduce inflation.
Other economists would suggest raising taxes to reduce spendable income by consumers, reducing business profits as well, and eventually reducing the amount of funds businesses are willing to invest. They could also suggest reducing government spending.
Both approaches result in a decrease in demand, however, which will reduce pressure to raise prices, but will also slow economic growth. If we look back in history, we can find a simple economic solution to this problem. That solution could be a tough sell, politically. But if anyone can do it, it is President-elect Donald Trump.
In the late 1970s, the American economy suffered from a severe stagflation problem. In other words, the economy was barely growing (stagnation) and the inflation rate was about to peak at an astonishing 13 percent. Hence, the term “stagflation.”
It became clear that traditional demand-side economic policies weren’t working, encouraging some economists to develop supply-side theories that ultimately worked splendidly under the Reagan Administration. They jump-started our stagnant economy and led to a significant boost in economic growth without accompanying hyperinflation.
The supply-side theory is relatively simple: Gear government policy toward increasing not only demand, but also supply. As customers begin to purchase higher quantities of goods, business is willing and able to produce more to meet the demand. The result in the 1980s was that the American economy grew robustly and inflation dropped rapidly and dramatically.
In the early 1980s, the inflation rate fell from its peak of approximately 13 percent to under 3 percent and stayed under 3 percent for more than 35 years. The American economy began to grow at a more rapid clip so that by 1984, annual economic growth exceeded 7.5 percent. The economy began a 26-year growth spurt that ran from 1981 to 2007, save for a couple of minor hiccups in 1991 and 2001.
Trump already understands this. In addition to simplifying the tax code and cutting taxes for all Americans, he plans to reduce our corporate tax rate to 15 percent, which will help make American goods far more competitive in international trade. This dramatic tax cut will instantly give firms more net profit and more retained earnings to invest back into the U.S. economy, further boosting growth. Trump will also reduce clearly counter-productive regulations and lift largely meaningless bureaucratic burdens from business large and small.
In this way, when the increased demand comes from consumers taking home more spendable income, business will meet the increased demand not by raising prices, but rather by expanding output. The result is little inflation and higher growth.
Politically, Trump’s plan may prove difficult to put in place, as the opposition will complain that Trump is “cutting taxes for wealthy corporations” who already don’t pay their “fair share.” And they will claim that Trump is cutting taxes for the highest income earners who similarly don’t pay their “fair share.” Trump’s response will be that it is the tax cut for the highest income earners that will create the investment capital needed for growth. Politically, however, this may be a tough sell.
But the counter-argument is hard to refute. Supply-side economics worked spectacularly 35 years ago. Now is the time to do it again.