Policy-makers don’t talk about the trade-offs involved in stimulus policies.
Policy-makers don't talk about the trade-offs involved in stimulus policies.
M any people have become aware of the sharp increase in many prices during the pandemic. Housing prices took off soon after the pandemic began, followed quickly by auto prices due to a shortage of semiconductor chips. By late 2020, many commodity prices were surging. Since then, price pressures have become widespread as a result of worsening backlogs in the global supply chain and labor shortages that are raising worker compensation. After first insisting that higher prices were a transitory phenomenon, Federal Reserve chairman Jerome Powell admits that “supply-side constraints have gotten worse. The risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation.”
Inflation is proving to be more than transitory because government interventions in the economy during the pandemic have created distortions in personal incomes and savings as well as in housing, commodity, labor, and financial markets. These distortions make inflation harder to forecast, although economists have long struggled to forecast inflation accurately. Many central banks have been slow to react to inflation, a problem compounded by how long monetary policy can take to affect the economy. More fundamentally, higher inflation in the short term and lower potential growth in the long term are the unintended consequences of the massive economic stimulus during the pandemic.
The return of inflation to its highest rate in three decades is significant for a number of reasons. Inflation has a clear negative impact on consumer sentiment. Higher prices erode purchasing power and will increase the upward pressure on interest rates, slowing the recovery from the pandemic. Higher interest rates will, in turn, have a significant impact on government finances, as interest on our growing national debt becomes a larger portion of the federal budget.
The headline number for inflation as measured by the Consumer Price Index accelerated to a 30-year high of 6.2 percent in October 2021. However, this might understate the actual inflation rate in an economy increasingly plagued by shortages. The CPI is ill-equipped to account for shortages since it was designed to measure prices in an economy where goods and services are abundant, not an economy of rampant shortages — and shortages are de facto price increases.
Wages have risen in response to the shortage of workers, even as pockets of long-term unemployment linger in some sectors. The faster wages rise, the more embedded inflation becomes. While sharp downturns in commodity and housing prices are common, it is rare for employee wages to be cut after they have risen.
Growing distortions in the economy
In the wake of the pandemic, it is increasingly evident that demand recovered faster than supply due to government policy creating numerous distortions that are persisting, and in some cases, worsening. On top of the consequences of lockdowns, these distortions include gains in household income (unprecedented during a recession), dislocations in the housing and labor markets, the mismatch of sectoral demand with industry supply, and heavy government borrowing.
The most striking distortion was the 9.8 percent increase in personal disposable income since the pandemic began. While employment and wages and salaries fell precipitously at the pandemic’s onset, this was more than offset by massive income support from government. The outright increase in incomes and huge increases in personal savings during the pandemic show that much government aid went to households that either did not need support, or at least that much support.
The government response to the pandemic distorted the labor market. The most obvious distortion is the coexistence of high rates of job vacancies and unemployment. The U.S. and Canadian governments sent aid directly to people rather than through employers, as many European nations did. This severed the relationship between employers and employees in North America, complicating the return to work and aggravating labor shortages. It is notable that Europe is experiencing less severe labor shortages after governments there administered aid to workers through their employers by treating them as on furlough; as a result, Europe’s rate of unfilled jobs is 2 percent, below its pre-pandemic level.
While aggregate demand in the U.S. returned to its pre-pandemic level, there were wide variations by industry. Demand soared in some industries such as real estate, retail goods, and professional services and lagged in other industries that struggled during the pandemic to cope with social distancing (mostly personal services). Instead of quickly shifting from broad stimulus for the whole economy to these specific sectors, policy-makers continued their focus on aggregate demand. As the economist Gottfried Haberler noted in 1945, applying macroeconomic stimulus to cure unemployment in a few industries is a recipe for what would in the ’70s become known as stagflation, “the paradox of depression and unemployment in the midst of inflation.”
Many sectors borrowed massive amounts of money during the pandemic. Higher debt boosts an economy’s growth in the short term but lowers its long-term potential. A study by the Bank for International Settlements examining data from 54 economies from the 1990s to 2015 concluded that “household debt boosts consumption and GDP growth in the short run, mostly within one year. By contrast, a 1 percentage point increase in the household debt-to-GDP ratio tends to lower growth in the long run by 0.1 percentage points. Our results suggest that the negative long-run effects on consumption tend to intensify as the household debt-to-GDP ratio exceeds 60%. For GDP growth, that intensification seems to occur when the ratio exceeds 80%.”
Economists have no working model of inflation
The resurgence of inflation underscores the ongoing failure of economists to understand price dynamics. Economists did not foresee the surge in prices because, in the words of former Federal Reserve governor Daniel Tarullo, they have no working theory explaining inflation. Macroeconomists have focused too much on short-term-demand management and too little on how stimulus lowers long-term potential growth, a problem Robert Lucas (Nobel laureate and doyen of macroeconomics) warned about in 2003.
Economists have no adequate theories of inflation. The oldest is the quantity equation linking prices to the money supply. While it is broadly true that inflation cannot persist without increases in the money supply, it has proven hard to define the money supply consistently. Moreover, linking prices to the money supply assumes money velocity is stable, which it often is not. Still, monetarism proved helpful in quelling inflation in the 1980s; Paul Volcker admitted to using the public’s widespread belief linking the money supply to prices as an anti-inflation tool because “more focus on the money supply [by the Fed] . . . would be a way of telling the public that we meant business. People don’t need an advanced course in economics to understand that inflation has something to do with too much money. If we could get out the message that when we say we’re going to control money, we mean we’re going to deal with inflation, then we would have a chance of affecting people’s behavior.”
It is noteworthy that all measures of the money supply have expanded rapidly since 2020. The money supply, credit, and inflation never took off after 2008 despite widespread suspicion over central banks’ “printing money” with quantitative easing.
Many (predominantly Keynesian) economic models of inflation traditionally used a version of the Phillips curve, which assumes a stable trade-off between inflation and unemployment. However, economists have been befuddled by its flattening, implying slack in the economy does not have a predictable impact on inflation. Inflation throughout the OECD over the past decade has been consistently below what the Phillips curve would have predicted. The blurred relationship between unemployment and inflation has led some to relabel it the “Phillips cloud.”
Attempts to improve the Phillips curve by augmenting it with inflation expectations did little to improve its recent performance as a predictive tool (to be fair, that is not what it was intended for). It didn’t help that there was a lack of clarity about which inflation expectations are relevant: those for households, businesses, or professional economists.
The implication is that while central banks monitor expectations, there is little evidence they are useful at signaling the trend of inflation, according to a new paper from Fed economist Jeremy Rudd. Firms set their prices based on actual cost and demand conditions, usually at the local level, rather than on expectations of economy-wide inflation. Tarullo concludes by advising his former central-bank colleagues that without a good theory of inflation, they should emphasize observable data on wages and prices. He then recommends that “once actual inflation is observed to be rising, argue for raising rates more quickly.” So far, central banks have been slow to react to rising inflation.
The difficulty of forecasting inflation led the Fed to change how it formulates policy. The Fed now waits for actual outcomes rather than relying on forecasts, a switch it trumpets as a shift to “evidence-based” policy. However, because of the lags in monetary policy, this implies the central bank can fall behind real-world events. This is why Claudia Sahm, a former Fed economist who briefed Powell, said, “The shift from forecast-based monetary policy decisions to outcome-based policy decisions is a radical shift.”
Unstable relationships among key variables are a recurring problem in macroeconomics. Instability is evident in the quantity equation linking the money supply to prices, the Phillips curve trade-off between unemployment and inflation, the Beveridge curve relating unemployment and vacancy rates, and the timing of the impact of fiscal stimulus. Writing long after he had left office, former U.K. chancellor of the exchequer Denis Healey lamented, “The fundamental concept of demand management had become unreliable. . . . It had become impossible to discover with any accuracy how much additional demand the government should inject into the economy so as to produce full employment.” We saw this during the pandemic, when much of government income support to households was saved, implying a considerable delay between when government transferred money and when it is spent.
‘Inflation is taxation without legislation’
Harvard economics professor Kenneth Rogoff argues the problem that economists have in understanding inflation dynamics is that “controlling long-run inflation is fundamentally a political-economy challenge, not a technocratic one.” Inflation in the 1960s and 1970s originated in the soaring costs of the Vietnam War and the Great Society (and the failure to adjust monetary policy to reflect this). Volcker in the 1980s explained that persistent inflation means “we have to ask ourselves about the nature of the economic, social, and political forces and attitudes that seem to have aggravated the difficulties of reconciling full employment with price stability.”
More broadly, inflation is symptomatic of an inability to agree on who will pay the record government debt incurred during the pandemic. Milton Friedman said, “The federal government is the engine of inflation — the only one there is. But it has been the engine of inflation at the behest of the American public, which wants the government to spend more but not raise taxes — so encouraging resort to the hidden tax of inflation. . . . Inflation is taxation without legislation.”
Friedman’s quote perfectly captures how the public unwittingly encourages inflation by voting for reckless fiscal policy. The Wall Street Journal characterized the various proposals in Congress to increase taxes on corporations or billionaires as a “hunt for money.”
Many macroeconomists fail to acknowledge short-term stimulus lowers long-term growth
Lucas famously declared that macroeconomics had succeeded because “its central problem of depression prevention has been solved.” Avoiding a depression during the 2008-2009 financial crisis and again during the 2020 lockdown suggests Lucas was right. However, this is a qualified victory for macroeconomics because the cost of massive stimulus is lower growth over the longer term. Either outcome represents a failure for Keynesian economics because, as former treasury secretary Larry Summers reminded us, “The Keynesian aspiration was not to merely reduce the amplitude of cyclical fluctuations, but also to increase overall growth.” Policy-makers never publicly warn that the price of short-term stimulus is lower longer-term growth with no net gain in GDP. Economists often take pride in pointing out the unintended consequences of government actions, but many have not done that for unrelenting macroeconomic stimulus.
The Great Recession perfectly exemplifies trading short-term stimulus for less long-term growth with no net improvement over time. U.S. growth in the decade after the onset of the Great Recession continued to lag despite the application of much more monetary and fiscal stimulus. Summers concluded the failure of extraordinary stimulus to produce a better outcome “should be a (if not the) principal preoccupation of contemporary macroeconomics.”
Society can rationally choose to reduce business-cycle volatility to have milder recessions, provided it knows this means less growth in the future. Rational choice implies that the decision-making is informed. However, policy-makers never present these trade-offs when implementing stimulus. To be sure, they are often focused on political advantage, rather than economic education, but that they can get away with avoiding a discussion of these trade-offs represents a certain failure by the economics profession.
People have to remain confident that central banks eventually will take decisive actions to avoid inflation becoming embedded in higher wages and expectations. It is critical to the Fed’s mission and its self-interest that it does so; the most important asset that central banks possess is their independence. If ever inflation resurfaces for an extended period, the legions of central-bank critics who have warned about the dangers of excessive stimulus will inevitably insist on more oversight of central-bank goals and methods. So it is not surprising that financial markets expect that central banks will soon begin raising interest rates. That may be painful, but it might not be bad news: The longer central banks delay, the larger will be the increase in rates. Consumers won’t relish that (and household debt increased marginally over the pandemic), but the real problem will be for governments, given how they massively raised their debt loads during the pandemic. Tapering is beginning, and sooner or later central banks (if they have any sense of their responsibilities) will back away from purchasing government debt. That gap will have to be filled, and quickly, or the upward pressure on interest rates will intensify, making a bad problem even worse.