Spending cuts won’t fix inflation

Does government spending cause inflation?

The short answer to this question is a yes!

However, as other factors too cause inflation to rise, government spending alone may not be inflationary.

Nevertheless, there is a limit to government spending, as higher spending means the government will be raising the aggregate demand in the economy and, at the same time, will be running a budget deficit, which can only be funded via borrowings.

The next question is what is the threshold level that will be inflationary to the economy due to government spending?

In this instance, an economist would probably measure and define the excessive level based on the budget deficit as a percentage of gross domestic product (GDP), the government’s debt-to-GDP ratio, as well as debt service charge as a percentage of total expenditure.

Inflation, as measured by the consumer price index (CPI), is the price level of goods and services in an economy based on a basket of goods that are chosen to reflect consumption patterns.

In general, most goods or services in the CPI basket are chosen to reflect consumer demand and they are measured monthly.

There are also two components of CPI – the headline CPI and the core CPI, which excludes volatile prices of fresh food and items that are under price control by the government.

A CPI measurement is also referenced against a base year, which in Malaysia’s case is the year 2010.

For example, in the case of Malaysia, the CPI reading for January 2025 stood at 133.60 points, which suggests that the cost of living has risen by about 33% over the past 15 years.

Is inflation relevant?

While it is used to measure the rate of change for a basket of goods and services, the monthly inflation print itself has a significant impact on many angles.

There is a varying degree of reliance on whether a central bank uses headline or core inflation as the key barometer in determining monetary policy.

However, for most central banks, the key gauge is the core inflation rate.

For the US Federal Reserve, the preferred inflation gauge is the core personal consumption expenditure (PCE), which is more comprehensive than the CPI as it includes a broader subset of goods and services prices, including substitutions based on price changes.

The central bank uses inflation data to set either interest rate or exchange rate policy.

In an environment where the inflation rate is rising, a central bank will take steps to raise rates to ensure that is it able to cool down the elevated level of inflation and to bring aggregate prices to a more tolerable level.

A central bank will cut rates when inflation levels are low or in a deflationary environment.

Inflation and central bank monetary policy have huge implications for capital markets.

When rates rise, bond prices will be under pressure, causing yields to surge, and higher borrowing costs could also have an impact on equity valuations. The vice-versa is true when rates are falling.

For a healthy economy, most central banks target a modest inflation rate, with 2% seen as appropriate.

Interest rates are also used to determine private investments and consumption.

When inflation rates are low, the private sector will be more encouraged to spend, which can spur the economy, while high inflation leads to savings, mainly due to higher borrowing costs.

Interest rates, driven by inflation, may also impact currency fluctuations, especially when rate differentials between the United States and domestic considerations are taken into account.

Portfolio outflows are common when interest rates are low in a domestic economy, vis-à-vis the United States or other developed economies.

Inflation can also influence wages as most governments and unions often link minimum wages and annual wage increases to inflation readings.

Additionally, inflation affects the input costs of businesses, which in turn influences the prices they set for goods and services.

Input costs for the production of goods and services are key in determining aggregate prices in the economy.

During and after the pandemic, one of the critical factors that drove inflation was the disruption in the supply chains, which caused end-product prices to increase drastically, mainly due to higher commodity prices.

Central banks around the world had no choice but to turn hawkish and raised interest rates drastically, right up to last year.

Since then, inflation prints have been rather tame in most countries but in some economies, they remain relatively high due to varying factors.

In the United States, the PCE has been climbing steadily over the past few months, with the December 2024 print at 2.6%, which is 0.5 percentage points higher than September 2024’s low of 2.1%.

Core PCE, on the other hand, has remained sticky, remaining at an elevated level of 2.8% for the past three months. (Note: This analysis does not take into account the January 2025 PCE data released yesterday).

Can the US cut inflation?

The newly created Department of Government Efficiency, led by none other than Elon Musk, recently commented that inflation can be lowered to zero if the government can cut its expenditure by US$4bil per day.

Musk’s idea of inflation is centred on government spending and that by cutting expenditure, the price level of goods and services will normalise.

Mr Musk has been misguided on two counts.

Firstly, it is not easy to cut US government expenditure by almost US$1.5 trillion per year when the government itself had a total budget expenditure of US$6.9 trillion last year.

Healthcare, social security and defence spending account for 58% of the total, while another 28% is related to debt servicing (13%), benefits for veterans and federal retirees (8%), and economic security programmes (7%).

The balance of 16% is spent on education, transport, natural resources and agriculture, science and medical research, law enforcement, international aid and others.

The US$4bil a day involves cutting down 21% of the government’s expenditure and that can only come from laying off civil servants and shutting down institutions.

The outcome of this is that households will be severely impacted and there is still no guarantee that inflation will be lower, especially now that the plan to impose tariffs from key trading partners is well in progress.

Secondly, while aggregate demand will be reduced if the government cuts its expenditure, the impact on the economy as a whole can be significant, potentially leading into a recession.

The US government’s expenditure is about 17% of GDP, and a 21% cut may result in a 3.4 percentage point reduction in the GDP, more than the 2.8% growth forecast for the United States this year by the World Bank.

In conclusion, while over-expenditure by a government can have an impact on inflation, many other determinants play a role.

Worse, cutting government expenditure abruptly may cause unintended outcomes, such as job losses and recession.

Much like president Donald Trump’s belief that tariffs can reduce taxes, Musk’s idea that cutting government expenditure will allow inflation to magically evaporate into thin air is simply a distinctive form of cognitive failure.