Biden’s ‘American Rescue Plan’ came at just the wrong time.
Biden’s 'American Rescue Plan' came at just the wrong time.
T he Chinese year of the tiger commences in February 2022, but for those following U.S. inflation, a ferocious year began in 2021. Consumers, forecasters, policymakers, and politicians hoping to keep their jobs have been gobsmacked by this year’s inflation burst. As recently as February 2021, with CPI inflation at 1.4 percent, the Philadelphia Federal Reserve Survey of Professional Forecasters 2021 CPI projection was 2.2 percent, with none of the 38 forecasts exceeding 3.21 percent. In the event, CPI inflation for twelve months through November has been 6.8 percent, representing the largest 12 month jump since the Arab oil embargo in 1973.
This sharp, unexpected spike is due to the combination of an unprecedented freak impact of the pandemic with the spectacularly ill-timed policy blunder of the Biden administration’s “American Rescue Plan.”
While conventional economic theory avers government deficits increase income and inflation, this relationship is difficult to establish. The correlation between government deficits and inflation has been zero since the mid 1990’s. It took a devout Keynesian such as Harvard professor and former Treasury Secretary Lawrence Summers to accurately forecast the Biden stimulus would boost prices.
No doubt, deficit stimulus, generally in the form of tax cuts or income transfers, can boost consumption. The chart below illustrates a strong relationship between government deficits and personal consumption expenditures:
The catch is government deficits lower investment. The bump to income from higher consumption is offset by lower income from reduced investment, including in inventories. The chart below shows higher consumption shrinking inventories:
Consequently, there is an indirect connection between government deficits and inventories, illustrated in the next chart:
The connection between inventories and the government deficit is a two-way street. Declining inventories can sometimes signal or trigger an economic downturn that increases deficits, but, operating via consumption, deficits affect inventories too.
The deficit-related effects of rising demand and shrinking inventories are exactly what characterize the current U.S. economy. Compounding the problem is the pandemic-inspired shift from consumption of services to goods. Goods’ share of total consumption has increased 16.5 percent over the course of a year.
A ratio comparison between the demand for goods, reflected in personal consumption expenditures for goods, and the availability of goods, represented by inventories, produces a strong indicator of inflation, depicted in the chart below:
The chart indicates a consumption/inventory ratio above 1.6 is accompanied by higher inflation. There is an approximate one-year lag from inventory tightening to the onset of inflation. Deficits from the March 2020 Trump administration CARES Act likely were affecting, consumption, inventories, and monthly inflation had risen above 5 percent annualized when the American Rescue Act was enacted in March 2021. Just as demand began outpacing inventories, as inflation began to increase, the American Rescue Plan deficit “stimulus” unwisely supercharged the process. Price pressures have spread rapidly from the goods sector to more labor-intensive services and are now rising across the board. The U.S. demand for goods has had global impact, boosting inflation throughout the world.
Each of the deficit stimulus measures represented the largest federal borrowings relative to GDP since World War II. Combined, they have had an unprecedented effect, explaining how so many economists misjudged their impact. As shown in the chart below, the two budget busters have produced two seeming spikes in inflation, first peaking in spring 2021, the other in the fall.
If these deficits are the cause of 2021’s inflation burst, their unwinding may well be the cure. Congressional Budget Office and Penn Wharton Budget model projections combine to forecast federal spending and deficit reductions for 2022 of 6-7 percent of GDP. Deficit declines of this magnitude should bring consumption down and inventories up to a point where inflationary pressure ends. As quickly as inflation has risen, it may have the potential to fall to more normal levels by 2023.
That is what analysts and financial markets are expecting as evidenced in market yields. The 30-year Treasury bond yield is around 1.80 percent. Ten-year breakeven CPI inflation rates estimated from Treasury Inflation-Protected Securities are near 2.40 percent. One of the most accurate estimates of future inflation is provided by the Cleveland Fed. Over the last 30 years, its average error magnitude (absolute value) on 10 year inflation is 0.5 percent, and its current forecast is 1.75 percent for CPI, indicating future inflation well below the Federal Reserve’s 2 percent target.
Based upon their failure to capture this year’s inflation upswing, these indicators and forecasts might be dismissed, but longer-term inflation forecasts often are more accurate than short-term. Random fluctuations affect one year but can balance out over time. For example, the Cleveland Fed forecasts are three times less accurate for one year than ten-year horizons. Once seen in the rearview mirror, this year’s inflation surge may resemble statistical noise, albeit deafening noise at current levels.
If U.S. deficits are driving recent inflation, then it likely will recede. Recent deficits are unsustainable, but there may be enough inflation still around come November 2022 to be fresh in voters’ minds. Sin in haste, repent at leisure, and in all likelihood too late for those responsible for the American Rescue Plan’s fiscal folly.