Will Spending Cuts Fix Inflation?

 

Does government spending cause inflation? Pankaj C. Kumar believes, yes! He hastily adds that other factors too cause inflation to rise. Higher spending means the government is raising the aggregate demand in the economy. Budget deficit balloons and they are funded by borrowings. 

What is the threshold level that will be inflationary to the economy due to government spending? Based on the indicators like 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 remain as pointers to any potential inflation increase.

 

Source: Investopedia

There are 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. 

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. 

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 wages 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. 

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). 

The newly minted Department of Government Efficiency, led by 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 is a little naive on, at least, two counts:

 

(i)          1.    It is not easy to cut US government expenditure by almost US$1.5 trillion per year when the government itself has a total budget expenditure of US$6.9 trillion. 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%).

 

    2.    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.

 

(ii)     While aggregate demand will be reduced if the government cuts its expenditure, the impact on the economy as a whole can be significant, 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 GDP. 

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 is a unique form of cognitive dissonance! 

Reference:

Spending cuts won’t fix inflation, Pankaj C. Kumar, The Star, 1 March 2025