With the 2022 elections looming, inflation tops the list of issues on the minds of voters. As prices climb faster and higher than they have in four decades, pressure mounts on politicians to do something to ease consumer pain. Of course, if tackling inflation were easy, lawmakers would be only too happy to take action and ensure their own job security.

Nevertheless, federal government decisions over the next several months will affect the trajectory of inflation to some degree. Who wins in November may well depend upon whether incumbents can separate effective economic strategies from longstanding beliefs.

Disputes Over the Root Causes of Inflation

Unsurprisingly, leaders cannot agree on why prices keep soaring. Some blame runaway government spending, while others focus on supply chain disruptions caused first by the pandemic, and now by the horrifying specter of war in Europe.

In reality, a vast web of factors can influence prices, and that web can be exceedingly difficult to untangle. For instance, most U.S. citizens have at least a vague understanding of the theory of supply and demand. And while that concept holds true to a point, most economists would agree it is far from a complete explanation of price trends.

It may be more useful to think of inflation as the product of two different supplies: the supply of goods, and the supply of currency. When the amount of money circulating through the system increases, consumers tend to feel comfortable spending more. In response, suppliers of goods and services then raise prices—either because boosting production involves greater expense or simply to seize a chance to widen profit margins.

As a rule, it is easier to adjust the amount of money in circulation than to reshape product supply chains. Therefore, most of the anti-inflationary measures under discussion center on stemming the flow of currency.

Traditional Monetary Policy Solutions

As America’s central banking authority, the Federal Reserve has the most direct means of tightening the nation’s purse strings. Collectively, actions taken by the Fed to influence the money supply are known as monetary policy.

Traditional monetary policy has centered on interest rates. High interest rates discourage borrowing and reward saving, thus reducing the circulation of money in the economy. Conversely, low rates make borrowing easier, accelerating the flow of money.

These trends suggest a straightforward recipe for Federal Reserve interventions. When prices rise, the Fed can raise interest rates to squeeze the currency stream. When economic activity stagnates (a recession), the Fed can drop rates to unleash a spending spree.

As a general rule, these strategies are effective. However, when the Great Recession hit in late 2007, interest rates were already low, leaving the Fed with little wiggle room. Today’s circumstances create a similarly vexing dilemma. In spite of impressive job growth, the economy still shows signs of fragility from the recent slowdown. Raising interest rates to tame inflation could stifle growth, resulting in the dreaded stagflation (a recession and inflation together). Unusual times such as these call for more creative approaches.

The Role of the Federal Reserve’s Balance Sheet

Followers of financial news have heard much talk lately about the Fed’s balance sheet. To boost the money supply in 2009 without overhauling interest rates, the Fed began purchasing treasury securities (bonds, T-notes, and T-bills). This activity, which continued through most of the 2010s, moved currency out of national reserves and into general circulation. It also radically altered the Fed’s balance sheet. By the end of 2021, the ledger included traditional treasury securities and other securities totaling nine trillion dollars.

In theory, by now selling some of these treasury holdings and sitting on the cash influx, the Fed can pinch the money supply without a major interest rate hike. Since the assets under Fed control add up to more than the total number of U.S. dollars currently in circulation, the effect could be dramatic. As a bonus, since the Fed cannot legally turn a profit, any interest gains from selling securities will be surrendered to the general government treasury.

Such a scenario almost makes tamping down inflation seem simple, which can only mean there is more to the story. The first problem lies in the market realities surrounding treasury securities. To sell bonds or notes, the Fed needs willing buyers.

Flooding the market with too many securities at once might drive bond prices down, which in turn could cause multiple problems. For starters, selling securities at a discount would result in removing less cash from the economy. Furthermore, discounted prices increase bond yields. That shift could actually drive general interest rates higher, which is exactly the scenario the selloff is intended to prevent.

In the end, using Fed resources to combat inflation requires hitting a sweet spot—just enough intervention and no more. Unfortunately, no one knows for sure where this “Goldilocks” zone  lies. This frustrating reality has many looking to Congress for solutions.

How Inflation Relates to Deficits and the National Debt

Many commentators point an accusing finger at budget deficits whenever inflation rears its head. The anti-deficit drumbeat has amped up of late, with the national debt (the cumulative effect of years of deficits) reaching a staggering $30 trillion.

When Congress spends more money than the government takes in, the Treasury must sell securities to make up the difference. The cash those sales bring in makes a revolving-door trip through Washington, swiftly heading back out in the form of government expenditures. Through this process, money can pour into the broader economic flow, seemingly a clear recipe for inflation.

This classic analysis appears to be entirely logical, but the data suggests it is also partly mythical. Federal budget deficits have been the norm for decades, and for most of that time, inflation rates have caused little worry. Clearly, the idea that deficits directly trigger inflation is another oversimplification of devilishly complex facts. The debate among economists has now shifted to what constitutes a “good deficit” or a “bad deficit.”

Effects of Tax Rates and Government Spending

No one disputes the basic math behind budget deficits. Balancing the budget would require increasing revenues, reducing spending, or both. Stereotypically, liberals want to keep spending and boost revenues by raising taxes for those who can pay more. Meanwhile, traditional conservatives want to curtail spending and keep taxes low.

Either model could be inflation-neutral, as they both involve one strategy that spurs money circulation and one that impedes it. By balancing the two competing forces in just the right way, Congress could either stimulate growth or slow inflation. Such budgetary strategies are known as economic fiscal policy. Unfortunately, the words “Congress” and “just right” rarely appear in the same sentence.

Complicating matters even further, the economic impacts of fiscal policy depend on who gets taxed and how federal money gets spent. Data suggests that spending on domestic programs supporting families and education provide a greater economic boost than defense spending, for example. A more robust economy can mean more people working and paying taxes, actually increasing long-term government revenues. Similarly, lower tax rates for the middle class could put consumers in a better position to spend, fueling economic expansion for a brighter budget picture down the line.

Theoretically, the perfect level of either targeted tax cuts or new spending would result in a net government gain over the long haul, hence the notion of a good deficit. However, in a familiar theme, experts cannot agree on what exactly would constitute this elusive optimal position. Moreover, even if progressive spending measures or conservative tax rates would lead to healthier revenues in future years, a step in either direction now could fuel the inflation fire.

Conclusion: Multifaceted Solutions for a Complex Problem

Problems with many causes rarely have one-dimensional solutions. In all likelihood, reining in the inflationary beast will require some combination of interest rate adjustments, Fed balance sheet reductions, and budgetary restraint. No one is likely to get exactly what they want in the bargain, but with measured decision making, we might all just get what we need.

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Harvey Bezozi: As one of the most knowledgeable and well-connected tax & accounting professionals in the world, Harvey Bezozi's mission as a CPA and CFP ® is to provide concierge-level work product and service, along with seamless communication, high energy, and a super-positive attitude. Located in Boca Raton, Florida, Bezozi has been in business since 1994, and serves clients in all 50 states and internationally. More information can be found at YourFinancialWizard.com.