Is High Inflation the New Normal?

Inflation in the United States was debated by economists during the second half 2021. The obvious reason for price rises was argued by inflation hawks, who claimed that massive fiscal stimulus and monetary stimulation were the causes. Pandemic-related disruptions in supply chains were the primary cause of rising prices, according to inflation doves. In early December, the debate suddenly shifted: Federal Reserve Chairman Jerome Powell told legislators, “it’s probably time to retire that word”—Temporary—and the hawks took a victory lap.

It’s easy to understand why Powell was so concerned. We are currently experiencing some of the most severe price pressures for nearly 40 years, with inflation at 7 percent. It is difficult to understand and predict inflation.

Inflation partisans often fail to recognize that they aren’t mutually exclusive. If public policy boosts demand while production bottlenecks hamper supply, there is no question about what happens to prices—up they go. Additional reasons exist to avoid confident claims by digging deeper into the issue.

According to Orthodox economic theory, fiscal stimulus and monetary stimulation can boost total spending or aggregate demand. There have certainly been plenty of both. American Rescue Plan Act was signed by President Joe Biden March 11, 2021. The top-line figure for the Act was $1.9 trillion. Expanding fiscal policy is increased spending by the government to increase output and job creation. However, deficit spending can be used because taxes offset the effect on aggregate demand.

The Fed’s current balance sheet is also growing. In late January, the Fed’s total assets increased from $4 trillion in early2020 to $8.9 billion today. Driven by these asset purchases, the M2 money supply—cash, checking accounts, and “near monies,” such as savings accounts and money market mutual funds—grew from $15.5 trillion in early 2020 to more than $21.6 trillion today. Americans have more money available to them.

Also, fiscal expansion and monetary growth don’t increase the supply of goods that people may want to purchase with this money. The economy was hampered by widespread COVID prevention policies. Transport gridlocks at sea, land and air makes distribution and production difficult. It is frustratingly difficult to find major inputs such as semiconductors. Additionally, there are frictions within labor markets such as increased unemployment benefits recently and disputes between unions over mandates for vaccines. It is independent of demand considerations that rising prices have a combined effect.

Inflation can be explained with a supply-and demand double whammy. However, both scenarios have their problems.

All that stimulus may not have the same expansionary effect on demand as you think. Scott Sumner (the doyen at the market monetarist school), writes in his book, “We know that budget deficits by themselves are not very inflationary.” Money Illusion University of Chicago Press Sumner points out the lack of inflation in the Reagan or Obama administrations. Both presided over increasing budget deficits.

Money was also not especially scarce during the first stages of pandemic. As the money supply ballooned, the velocity of money—its average rate of turnover—cratered. The extra cash was held by people. Data from Federal Reserve Bank of St. Louis shows that money demand rose by 22.5% between the fourth quarter of 2019, and the first quarter of 2020. As the money supply grew, velocity remained low. Monetary conditions were relaxed because demand outpaced supply. However, Fed policy was not able to open the floodgates of liquidity as initially thought.

Congested production lines and slow distribution are clearly causing inflation. However, this explanation may not be true for all cases. Sector-specific supply conditions can vary widely. The aggregate data used to obtain a complete picture is less accurate on the supply than on the demand.

Politics must also be considered. There is a possible partisan resistance to indict technocrats or policy makers behind their inflexible belief that supply problem matters most.

They aren’t out of the woods yet, though. Mid-November was the peak of market inflation expectations. In January bond traders expected inflation to rise by 2.8 percent annually over the next five-years. They aren’t convinced that runaway inflation is inevitable. A wise man once stated, “Predictions can be hard especially when it comes to the future.” How fast Fed policy is tightened and supply constraints are eased will have a significant impact on the economy.