The big squeeze
Why Minnesotans are feeling the economic pinch.
In April, KSTP news reported that “Although abortion remains a top issue…the economy is the most important issue influencing voters in 2024.” It continues: “According to our new KSTP/ SurveyUSA poll, 28% of ‘likely voters’ cited the economy as the most important issue, followed by immigration at 15% and health care at 12%.” Abortion and gun control scored just seven percent each.
So, nearly four years into “Bidenomics” and “Building Back Better,” why are Minnesotans concerned about the economy?
For an answer, we must go back to March 2020 when COVID-19 policy responses shut down large swathes of the economy. From February to April, personal consumption expenditures plunged by 17.4 percent and the unemployment rate rose from 3.5 percent to 14.8 percent — an extra 17.4 million people were out of work. Businesses, desperate for cash, began selling assets — including Treasuries. This lies at the heart of America’s current economic concerns. We must enter the nexus of fiscal and monetary policy to understand why.
Fiscal and monetary policy
When a government wants to borrow money, its treasury essentially prints a piece of paper — also known as a bond or security — promising to pay the holder, say, $10,000 in 10 years. The treasury sells this piece of paper for cash, but not — or almost certainly not — for $10,000.
Why not? Consider the question from the buyer’s perspective. You have $10,000 and the treasury is offering to take that and return it to you in 10 years: Where is the benefit to you? To incentivize the buyer to part with their cash, the treasury sells the bond for, say, $9,000. Now, the buyer hands over $9,000 and gets $10,000 back 10 years from now. The yield, or interest rate, is $1,000 — or 1.1 percent annually.
It follows from this that when the bond’s price goes up, the yield goes down, and vice versa. Like any other price, bond prices are driven by supply and demand. If bondholders begin selling as they did in March 2020, then ceteris paribus, bond prices fall and yields rise. From March 9 to March 18, annual Treasury yields — what the government pays to borrow — rose from 0.54 percent to 1.18 percent on the 10-year Treasury bonds and from 0.99 percent to 1.77 percent for the 30-year bonds.
This was terrible timing. A vast fiscal package was being assembled to ensure that, as then Pres. Donald Trump explained, Americans “impacted by the virus can stay home without fear of financial hardship.” The last thing the federal government needed was for the cost of funding that package to spike. To keep borrowing costs down, an agency needed to buy bonds en masse, propping up their price and stopping their yields from rising. The central bank, with its unlimited capacity to produce the necessary money, was the obvious candidate.
On March 3, the Federal Reserve, under Trump’s appointee Jerome Powell, cut the Fed funds rate to 1.0 to 1.25 percent, but this was immediately overtaken by events. At an emergency meeting on March 15, the Federal Reserve decided to cut the rate to 0 to 0.25 percent and purchase at least $500 billion in Treasuries and $200 billion in mortgage securities. In the following days, the Federal Reserve pumped liquidity (newly created money) into one market after another. On March 23, the Federal Open Market Committee announced that it would “purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.”
“Over the week that followed,” historian Adam Tooze writes in Shutdown: How Covid Shook the World’s Economy,
…the Fed bought an astonishing total of $375 billion in Treasury securities and $250 billion in mortgage securities. At the high point of the program, the Fed was buying bonds at the rate of a million dollars per second. In a matter of weeks, it bought 5 percent of the $20 trillion market.
Monetary policy had set the stage for fiscal policy. On March 25, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act: $2.2 trillion — 10 percent of the United States’ Gross Domestic Product (GDP) — of extra spending, tax cuts, and funding allocations. It was “the largest slug of fiscal support ever delivered to an economy–anywhere, ever,” Tooze notes, adding, “At its peak, in the week ending May 1, the federal government was pumping $200 billion per week into the economy. The rate of emergency spending did not fall below $50 billion per week until the third week of May.” The federal budget deficit for 2020 was 15 percent of GDP, the highest since World War II.
To keep this affordable, the Federal Reserve’s Total Assets grew by 115 percent between February 2020 and April 2022 with the Monetary Base — which comprises total balances maintained plus currency in circulation and is under the Federal Reserve’s direct control — growing by 86 percent between February 2020 and December 2021 to finance it. Yields on the 10-year Treasury stayed below one percent until December 2020 and below two percent on the 30-year until January 2021. “[T]he most succinct answer to the question of how epic government deficits could be financed without driving up interest rates,” Tooze writes, “was that one branch of government, the central bank, was buying the debt issued by another branch of government, the Treasury.”
Inflation
Economist Milton Friedman wrote, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” With GDP — or output — contracting by 9.1 percent in real terms between the fourth quarter of 2019 and the second quarter of 2020, wouldn’t the Federal Reserve’s money creation generate inflation?
Experts said no. A CNBC article in July 2020 titled, “Here’s why economists don’t expect trillions of dollars in economic stimulus to create inflation” noted that “So far, weak demand has muted prices across advanced economies.” “In the United States,” Tooze writes:
…those on lower incomes stashed their CARES checks and repaid debts in anticipation of tough times to come. Higher income households were stuck with the money, unable to splurge on holidays and dining out. Even with a stimulus check in hand, no one was keen to go out to eat or to the beauty parlor or dry cleaner. In April, the savings rate in the United States shot up from an average of 8 percent in 2019 to 32.2 percent, the highest figure ever recorded.
If inflation was, in Friedman’s words, “too much money chasing after too few goods,” money wasn’t doing the “chasing” necessary to generate it.
And maybe it wouldn’t. “Economists say another reason inflation might stay low is that the link between money creation and consumer prices has weakened in recent years,” CNBC explained. “When the Fed bought trillions of dollars in assets after the 2008 financial crisis, inflation never surged.” CNBC concluded: “The latest projections from Federal Reserve policymakers show inflation will stay below the central bank’s 2% target over the next two years.”
This forecast was holding when Pres. Biden was inaugurated in January 2021; annual growth in the Consumer Price Index (CPI) — the inflation rate — was 1.4 percent. From February 2021 to its peak in June 2022, the annual rate of inflation rose to 9.0 percent, the highest since November 1981. The experts consulted by CNBC were wrong. As economies reopened, demand surged: All that new money started chasing goods and services, bidding their prices up.
It was wrong to generalize from the experience of Quantitative Easing (QE) between November 2008 and October 2014 that “the link between money creation and consumer prices [had] weakened.” Back then, Ben Bernanke’s Federal Reserve gave newly created money to financial institutions in exchange for toxic assets to shore up their balance sheets, but the institutions did not use the new cash as the basis for new lending. So, while the Monetary Base increased by 252 percent over this period, the broader measure of the money supply, M2 — which comprises the cash that people have in hand or in short-term bank deposits, changes in which are more closely related to changes in the rate of inflation — increased by just 45 percent and inflation remained relatively low.
This was very different from injecting newly created money directly into the economy via the CARES Act. Between February 2020 and December 2021, while the Monetary Base grew by 86 percent, M2 grew by 39 percent, a more similar change indicating a closer link between Monetary Base expansion and M2 expansion. This, with a lag, drove the inflation that exploded in 2021.
Bidenflation
On the campaign trail, Pres. Biden declared, “Milton Friedman isn’t running the show anymore.” However, the defiant slogan proved to be just another soundbite. He could have claimed that he inherited “Trumpflation,” but Biden had only ever criticized Pres. Trump’s policies for not being expansive enough. As a result, he was reduced to lashing out at a range of unlikely economy-related culprits. “Supply chains” were blamed despite real output regaining its pre-COVID peak in the first quarter of 2021; businesses mysteriously became greedier in 2021 than previously; and Russia’s invasion of Ukraine in February 2022 had somehow caused the annual rate of inflation to rise from 1.4 percent to 7.6 percent in the year preceding it.
Then the Biden administration added fuel to the fire. Besides a low inflation rate, it inherited an unemployment rate of 6.4 percent and two quarters of real GDP growth. Nevertheless, it believed the economy needed further stimulus and proposed the American Rescue Plan (ARP) totaling $1.9 trillion, an infrastructure bill of $2.3 trillion, and the American Families Plan of $1.8 trillion. The non-partisan Committee for a Responsible Federal Budget estimated that the ARP alone would exceed the “output gap — the difference between actual economic activity and potential output in a normal economy…two to three times over.” Larry Summers, treasury secretary under Pres. Bill Clinton, said, “I think this is the least responsible macroeconomic policy we’ve had in the last 40 years.”
And, again, this was terrible timing. In May 2024, the Congressional Budget Office (CBO) forecast a federal budget deficit of 5.6 percent of GDP in 2024 rising to 8.5 percent in 2054 when debt held by the public would hit 166 percent. This is largely driven by entitlement programs such as Social Security and Medicare, but not entirely. In 2022, Biden added the $891 billion Inflation Reduction Act (IRA) to his already-passed ARP and infrastructure bills. It was never clear how the IRA would reduce inflation, but it is proving to be more expensive than originally promised. The CBO originally scored the IRA as a deficit-reducing policy but now estimates that it will increase the deficit.
This comes at a time when Treasury yields have risen from below one percent in December 2020 to above four percent since December 2023 for the 10-year — the highest since 2008 — and from below two percent in January 2021 to above four percent since August 2023 for the 30-year — the highest since 2011. This is the nightmare scenario of March 2020: The amount of borrowing and the cost of borrowing rising at the same time.
The solution and the outcome may be similar. The Monetary Base fell by 17.0 percent from December 2021 to February 2023 but has since increased by 10.5 percent; M2 fell by 4.7 percent from April 2022 to October 2023 and has since risen by 0.7 percent; and the annual rate of inflation, which plunged from 9.0 in June 2022 to 3.0 percent in June 2023, has stopped falling. Despite repeated assurances from people such as Treasury Secretary Janet Yellen that inflation was “transitory,” the annual rate has now been above three percent in every month since March 2021 and analysis by the Federal Reserve Bank of Cleveland suggests that “it may take several years for inflation to return to the Federal Open Market Committee’s two percent target.” Robert Kaplan, former president of the Federal Reserve Bank of Dallas, recently urged the Biden administration to “slow the implementation of the Inflation Reduction Act to slow inflation.” If rates remain stable over the next year, the federal government will pay a total of $1.7 trillion in interest payments in the 12 months to April 2025. It is no coincidence that Powell now says that Quantitative Tightening — the sale or run off of assets owned by the Federal Reserve to reverse QE — will slow.
Reality bites
While Biden seeks scapegoats for the inflation he inherited and that his policies are fueling, Americans are suffering. As prices rise faster than earnings, real incomes are squeezed. Adjusted for inflation, Average Hourly Earnings fell by 4.3 percent from Biden’s inauguration to June 2022 and are still 2.7 percent lower than when he took office. From 2020 to 2022, Median Household Income rose by 9.7 percent in nominal terms but fell by 2.7 percent in inflation-adjusted terms. Household Net Worth, adjusted for inflation, increased by just 0.7 percent between the fourth quarter of 2020 and the fourth quarter of 2023, the smallest increase over such a span since 2011. Americans coped by running down those record COVID-era savings, which declined from 32.0 percent of disposable personal income in April 2020 to 2.7 percent in June 2022 — money “chasing” in action.
This is why Minnesotans are concerned about the economy despite repeated assurances that it is “strong.” The massive monetary expansion of 2020-2021 in support of vast fiscal measures to cushion people from the effects of COVID shutdowns has fueled the highest rate of inflation in four decades, putting the squeeze on living standards. Minnesotans do not judge the economy by parsing the latest data releases but by asking themselves the age-old question: “Are you better off than you were four years ago?” For too many, the answer is a resounding, “No.”