The Federal Reserve is primed to do a very foolish thing over the Republican tax bill

If the Republican tax bill passes, the Federal Reserve might speed up its rate hikes. Big mistake.

Up the interest rates go.
(Image credit: Ikon Images / Alamy Stock Photo)

If the Republican Party actually passes its tax package, will the Federal Reserve speed up its interest rate hikes? At the moment, Fed officials are planning only one more rate hike this year, followed by three in 2018. But after speaking with several policy officials and economists, Bloomberg reported on Monday that if the tax bill goes through, "Fed policy makers may lift their rate projections for 2018 to four at their [December] meeting." So yeah, Fed officials could very well speed things up.

But let's be clear: If they do, they're fools.

The theory behind sped-up rate hikes is that the tax bill will drive inflation higher than it otherwise would've gone. That will force the Fed to increase interest rates to get ahead of the price surge and tamp it down.

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But how would the tax bill presumably increase inflation? According to the logic of the bill's supporters, the tax cuts will encourage businesses to invest more in the economy, by letting them keep more of the profits generated by those investments. That will create more jobs, tighten the labor market, and raise wages. Then businesses will hike prices to keep their profit margins up in the face of rising labor costs, and voila: inflation.

In other words, worries that the GOP tax bill will drive up inflation rest on trickle-down economics.

This is silly: Businesses don't simply create jobs and raise wages out of the goodness of their hearts. They do so to stay competitive, to increase market share, and to take advantage of untapped demand. What drives those calculations is customers having more money to spend. As companies create more jobs to tap that demand, they soak up all the available labor, forcing them to raise wages to keep attracting workers. Tax rates on business profits are neither here nor there.

But don't take my word for it. Here's forever Brightcove CEO David Mendels making the same argument. And here's a whole gaggle of CEOs at a recent Wall Street Journal event with White House economic adviser Gary Cohn. When the moderator asked the crowd how many would increase capital investments in response to the tax bill, barely anyone raised their hand. (Cohn, amusingly enough, seemed genuinely befuddled.)

Yes, businesses invest in job creation and capital in pursuit of higher profits. But over the same time period that investment in the U.S. economy collapsed, corporations' after-tax profits soared. What we have here is not a case of business investment being held back by high taxes; it's a case of aggregate demand being so low there's no market demand to tap. That also means employees don't have the leverage to demand pay hikes, which is how profit margins have stayed so high. Cutting taxes on businesses will do nothing but drive those profit margins higher still.

If you really wanted to increase aggregate demand, you'd need to significantly cut taxes on the poor and the working and middle classes. They spend far more of their income than they save. The tax bill does a little of that in its first 10 years, but not enough to make a serious difference. In its second 10 years, it raises taxes on those groups, which will lower aggregate demand and inflationary pressure.

But let's say, by some miracle, the Republican tax overhaul did lead to a whole bunch of new jobs and wage hikes. Why would the Fed raise interest rates to kill it off? Aren't more jobs and rising wages a good thing?

Some economic commentators and Fed officials will argue that, with unemployment down to 4.1 percent, the economy is already close to full capacity. It won't take much more aggregate demand to employ the people who still don't have jobs, at which point inflation will start rising.

But government statistics severely understate the amount of slack that's still in the labor market. On top of the roughly seven million Americans counted as officially unemployed, there's probably another 10 million who could be brought back into the workforce. We're a lot further below full capacity than the economic mainstream thinks, and fiscal policy doesn't force the Fed to pick between higher interest rates and higher inflation until we've hit that threshold.

It's also worth noting that wages for working- and middle-class Americans have basically stagnated for decades. The world's not going to end if we allow the economy to overheat for a few years and run inflation at 3 or 4 percent. Meanwhile, it would give workers the chance to claw back a lot of the ground they've lost.

Core inflation is still unable to even reach the Fed's 2 percent target, much less exceed it. So the central bank's plan for three rate hikes next year is far too aggressive as it is.

Longer term, it would be better if we relied on fiscal policy to keep upward pressure on aggregate demand, rather than leaving the Fed alone to balance between employment and the price level. And the GOP's tax bill is the polar opposite of the fiscal policy that would create that upward pressure anyway.

So if, by some miracle, the Republicans actually pass this thing, the Fed should keep calm and leave interest rates where they are.

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Jeff Spross

Jeff Spross was the economics and business correspondent at TheWeek.com. He was previously a reporter at ThinkProgress.