Amid the ongoing challenges posed by inflation, there are increasing reasons for prudent optimism. Recent data suggests that inflation is displaying signs of cooling to such an extent that the U.S. Federal Reserve decided to put a temporary pause on the raising of interest rates.
But before the war on inflation is won, policymakers will likely need to navigate a new set of factors adding to the complexity of the situation.
Promising numbers
Despite a decrease in inflation to 4% from its peak of 8%, the measures implemented by several first-world countries to address this issue, such as raising interest rates, have inadvertently heightened the risk of deflation and the potential for a recession.
This presents a formidable challenge for the Federal Reserve, as they must delicately balance the task of reining in inflation while also ensuring a smooth economic transition that avoids a downturn.
While there are reasons to believe that a soft landing may be achievable, another obstacle that could hinder progress looms on the horizon.
Historical examples
Throughout history, there are two recurring themes of countries that have experienced persistent inflation and at times eventually spiraled into hyperinflation: economic uncertainty and mounting debt.
Economies such as Hungary and Greece in the aftermath of WWII, or France following their costly war campaign during the 18th-century revolution, not only faced shaky economic conditions but also experienced severe bouts of inflation as deficits continued to widen. Unfortunately, a similar pattern seems to be emerging on the Federal Reserve's balance sheet.
Adding a debt crisis to the equation
Since the initial measures were implemented in response to the COVID-19 pandemic in March 2020, the national debt of the U.S. has surged by nearly one-third, reaching an astounding record of $32 trillion today.
This ever-growing burden could potentially add further inflationary pressure on the economy, placing the Federal Reserve in an extremely delicate position as it seeks to implement policies that not only curb inflation and achieve a soft landing but also address the pressing issue of a mounting debt crisis.
The reasons for this are threefold. First, when a country has a significant amount of debt, it can create challenges for the central bank in managing inflation through traditional methods. Typically, central banks raise interest rates or implement measures to reduce the amount of money circulating in the economy to control inflation. But this strategy of raising rates creates a dilemma as it can make it more expensive to pay off debt.
In some situations, when a government has difficulty repaying its debts, it may resort to a process called debt monetization. This means the government's central bank starts financing government expenses by creating new money, a method recently employed by the Federal Reserve. However, debt monetization can have consequences as it can potentially lead to an increase in the overall money supply. If this increase isn't matched by an increase in the production of goods and services, it can contribute to rising inflation.
Perhaps most problematic is the situation between soaring debt levels and the erosion of confidence in a country's fiscal stability. If investors and the public perceive that the government's ability to manage its debt is questionable, it can lead to higher inflation expectations. These expectations can become self-fulfilling as individuals and businesses adjust their behavior in anticipation of rising prices, exacerbating inflationary pressures.
Some necessary context
To counter the portrayal of the current inflationary environment as borderline dire, it is important to note that the U.S. does hold distinct advantages compared to infamous scenarios of hyperinflation seen in the Weimar Republic in Germany during the 1920s and more recently among countries like Venezuela, Zimbabwe, or Argentina.
One advantage is that the U.S. dollar remains the global reserve currency, providing a level of stability and confidence in its value. Additionally, the Federal Reserve has a relative degree of independence compared to other central banks, which can act as a safeguard against extreme inflationary scenarios.
While the U.S.'s position as a leader in the global economy certainly helps in combating inflation, it's crucial to acknowledge the additional challenges posed by rising debt. The task of achieving a soft landing could become even more difficult when coupled with an expanding debt burden.
It would be unwise to become complacent and assume that inflation will continue to decline steadily, or that the worst is behind us. Reason for optimism exists, but the U.S. has not fully emerged from the inflationary challenges it currently faces.
