We learned this morning that January was another record-setting month for inflation. Last month, consumer prices grew at a 7.5 percent annual rate — a new four-decade high. How much of the surge in prices is due to President Biden’s $1.9 trillion March stimulus, known as the American Rescue Plan? My answer: around three percentage points in 2021.
Senator McConnell mentioned last week on the Senate floor that “a full year ago” I “testified that Democrats’ spending could corner the Fed and force them to clamp down on the recovery sooner than necessary.”
The model I used in that congressional testimony wasn’t based on a Phillips curve, which would predict changes in inflation based on the expected drop in unemployment. Decades of low and stable inflation has meant that estimates of the slope of the Phillips curve likely only apply to regimes with stable inflation.
Instead, I used a simpler model that I described here at NR about a year ago, in February 2021. First, take the amount of goods and services the economy could produce at a sustainable pace if all available workers were on the job and all economic resource were being used at capacity. Then, consider actual economic output, which this time last year was lower than the economy’s underlying potential. The difference between the two is the extent to which economic production is falling short of what it “should be.” Economists call this the “output gap.”
A goal of economic stimulus is to make up the gap by boosting the demand for goods and services. The president’s $1.9 trillion stimulus would have filled the gap many times over. But importantly, not every dollar the government gives to households, unemployed workers, businesses, or state and local governments is immediately or even quickly spent. On the other hand, some dollars of federal spending eventually generate more than one dollar in economic activity because one person’s spending becomes another person’s income, which in turn becomes the second persons’ spending, which creates income for a third person, and so on.
Estimates of the effect of $1 of government spending on overall economic output range widely — say, from around $0.50 to $2.50 — and depend on many factors, including the type of spending and the amount of slack in the economy. Call the boost to actual economic output from $1 of federal spending “the multiplier.”
Last February, all plausible estimates of either the output gap or the multiplier predicted that the ARP would generate substantial inflationary pressure in 2021 and 2022.
We now have data on how 2021 unfolded. Using the same method, if you twist my arm and press me for an answer to the question I posed in the first paragraph, I’d say that around three percentage points of inflation in 2021 were due to the ARP.
It’s important to note the considerable uncertainty around that estimate. The pandemic has made it even more difficult than it normally is to estimate the underlying productive capacity of the economy and the extent to which federal spending will affect actual economic output. I can produce estimates that are both higher and lower than three percentage points. But that magnitude is in the midrange of reasonable estimates.
What does this mean for fiscal policy? Simple: Do no harm. Inflation will be elevated this year. Congress should not compound that problem with additional, large, deficit-financed spending packages.
The Fed is considerably behind the curve. It should immediately stop purchasing long-term assets. It should signal a willingness to hike the short-term policy interest rate at every meeting in 2022, along with indicating that it is considering raising rates by 50 basis points at some meetings rather than 25 basis points.
The ARP was a major factor in driving inflation. It’s up to the Fed to address the fallout.