How much longer will high inflation plague the US economy? Both the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCEPI) have grown faster than 2 percent (annualized) every month since March 2021. Inflation peaked during the summer of 2022 and has since fallen. Yet, it remains stubbornly elevated.
Much depends on the economic priorities of the Trump administration. I think many economist’s fears about the inflationary effects of trade and immigration restrictions are exaggerated. This is disputable, of course, and we should have a good-faith public debate. But let’s not lose sight of the big picture: monetary and fiscal policy still matter most.
Trump returned to the White House largely because the public was angry about dollar depreciation in the form of higher prices. His unusual coalition of nationalist-populists, old-school conservatives, and converted tech overlords has a material interest in bringing inflation down. But interests alone aren’t enough. The president, his team, and his allies in Congress will need to make politically hard choices to keep the dollar’s purchasing power from eroding further.
Monetary policy drives inflation. Before the covid pandemic, the monetary base (M0) stood at $3.5 trillion. The broader (M2) money supply was $15.4 trillion. Then, the Fed opened the floodgates: the monetary base and broader money supply shot up to $6.4 trillion and $21.9 trillion, respectively. Unsurprisingly, printing and spending a bunch of money pushed up prices. While there are good arguments for central banks to stabilize overall demand in the economy, it’s clear they went overboard.
If Trump is serious about inflation, fixing the Fed should be priority one. He should support legislation forcing the Fed to focus on the price level and use his political capital to get legislators on board. The Fed’s famous dual mandate of full employment and stable prices should be a single mandate: stable prices only. Don’t give monetary technocrats an excuse to take their eye off the inflation ball.
What about fiscal policy? Several economic theories assert a link between deficit spending and dollar depreciation. The most plausible is the fiscal theory of the price level. Deficit spending, so long as the public thinks it’s permanent, causes the dollar to depreciate because the dollar derives its value from anticipated future budget surpluses.
One way to interpret the fiscal theory of the price level is as a monetary theory of the price level, plus some political economy: large deficits increase the chances the government will have to use the printing press, rather than future taxes, to pay its debts. Deficits today thus portend debasement tomorrow, and anticipating tomorrow, dollar holders liquidate their positions today. This brings about the anticipated debasement.
The solution here is simple: Trump must rein in deficit spending. But this is much easier said than done.
Spending has greatly outpaced revenue since 2020. The first covid-year deficit was a whopping $3.1 trillion. It’s since fallen, but still was in the neighborhood of $2 trillion last year. As a percentage of GDP, those figures are 14.7 and 6.1 percent of GDP, respectively. Even if we throw out 2020-2022 on account of the covid emergency, the subsequent years set records for (peacetime, non-emergency) spending.
The Biden administration deserves much of the blame for our nation’s fiscal woes. But Trump is also culpable. He acceded to massive spending during the final year of his first term, including a procedurally odious omnibus spending bill in December 2020. Despite promising to balance the budget on the campaign trail, he blew out the budget during his first term.
Perhaps Trump is in store for a fiscal redemption arc. He should declare any spending bills that arrive on his desk dead on arrival if they increase the deficit faster than the economy is growing. The upper limit on deficit spending should be 2.5-2.7 percent of GDP. He should use lawful executive authority to end Biden-era spending programs, repurposing and even canceling unspent funds. And he should ensure the Department of Government Efficiency (DOGE), spearheaded by Elon Musk, has his support when it inevitably proposes unpopular yet necessary reforms.
Trump has the luxury of being term-limited; he is constitutionally ineligible to stand for reelection. The time to make a stand is now.
Reforming the Fed and curbing deficits are two of the hardest things to do in Washington. They probably won’t be accomplished by conventional politicians seeking long careers. As an outsider at the apex of his popularity, Trump has a unique opportunity to rein in irresponsible monetary policymakers and discipline spendthrift fiscal policymakers. He and his movement may enjoy continued success without these changes, but the cost will be failing at the main task the electorate gave him.