The writer is a professor at Columbia Business School, author of “The Wall and the Bridge” and served as Chairman of the Council of Economic Advisers under President George W Bush
US inflation has been extremely high since the economy emerged from Covid-19 (although annual consumer price growth slowed to 7.7% in October). Much of the analysis of this phenomenon has focused on the mix between “supply” and “demand” factors and Federal Reserve policy errors. While both of these areas are important, so are overspending. Understanding this can offer lessons for policy makers on what to do now and how best to respond to future crises.
During the pandemic recovery, supply factors such as high energy prices, broken supply chains and business closures helped fuel inflation. Research by Julian di Giovanni at the Federal Reserve Bank of New York suggests that supply shocks could account for 40% of inflation, with the remaining 60% coming from aggregate demand shocks. Admittedly, excess demand remains a very important generator of high inflation.
The Fed’s expansionary monetary policy in the post-pandemic era, along with forward guidance and a new framework suggesting continuation of these policies, have increased demand in an economy hit by supply constraints. Even by the end of 2020, the Fed was arguably behind the curve. By only raising the federal funds rate in the spring of 2022, it has lost control of inflation. But while the central bank can be blamed for misjudging the state of aggregate demand and lagging the curve for so long, fiscal policy has also played a significant role in pushing demand higher. ‘inflation.
The Covid-19 experience is instructive. While the initial economic shock reflected supply chain disruptions and blockages, there were real risks of a sharp decline in aggregate demand due to job losses and loss of production and investment. Quick responses such as the Cares Act, passed in March 2020, have focused on maintaining worker incomes and business continuity during lockdown. Early action prevented a slump in aggregate demand, but as the economic recovery took hold, additional federal spending — particularly the American Rescue Act blast — added to demand in a struggling economy. the limited supply. Again, this proved to be a recipe for inflation.
Economists, notably John Cochrane of the Hoover Institution, have formalized the link between fiscal policy and inflation. Suppose, Cochrane argued, that during the pandemic and recovery, the government dramatically increased spending, choosing not to cut other spending or raise taxes (this is, in fact, similar to the fiscal path followed). And let’s also assume that the government does not default on the treasury bills issued. To cover higher borrowing, “income” must come from reduced nominal debt values via higher inflation. Adjusting to above-baseline spending in the Trump and Biden administrations would require a short-term surge in inflation to reduce the real value of the debt.
According to this interpretation, inflation will remain high until the cumulative effect on the price level reduces the real value of the debt enough to pay for the higher expenditure. Since this price increase was largely unanticipated, nominal interest rates on Treasury issues did not rise at first. And, even if the higher price level due to spending is permanent, inflation should return to trend if the Fed pursues policies consistent with its 2% inflation target.
To see excessive government spending as culprits along with the Fed’s accommodative monetary policy, it is useful to contrast the policy of the 2008 global financial crisis and the subsequent economic recovery. As during the pandemic, the Fed has long kept nominal short-term rates at zero and more than quadrupled its balance sheet. Inflation and inflation expectations have remained anchored at around 2%—with actual inflation at times lower—in the decade since the onset of the financial crisis. A key difference, however, was that the fiscal policy expansion was relatively weak compared to that of the pandemic recovery.
Particularly after the results of last week’s midterm elections, there are three lessons for today’s policymakers. First, large increases in spending during a crisis affect inflation, not just real aggregate demand in the economy. Second, to reduce the risk of a spending explosion and resulting inflation, policymakers might consider pre-committing to more modest spending in response – on unemployment insurance benefits, rebates individual and/or transfers to the state – triggered by changes in production or employment. Finally, despite the temporary fiscal push, the Fed should pursue a monetary policy consistent with its long-term inflation objectives.
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