Is High Inflation the New Normal?

Inflation in the United States was debated by economists during the second half 2021. According to inflation hawks, massive fiscal and monetary stimulus is the main cause of rising prices. 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.

You can see why Powell was worried. The current inflation rate of 7 percent is the highest in almost 40 years. It is difficult to understand and predict inflation.

The inflation fight is often fought by partisans who fail to see that the stories of both sides are interrelated. If public policy boosts demand while production bottlenecks hamper supply, there is no question about what happens to prices—up they go. Further research into this debate will provide additional reasons not to make confident statements.

The Orthodox theory of economics states that fiscal and monetary stimulus may increase total expenditure, which economists refer to as aggregate demand. Both have been used. 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 balance sheets have also grown. 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 are more likely to have money to spend.

Also, fiscal expansion and monetary growth don’t increase the supply of goods that people may want to purchase with this money. A wide-spread COVID preventive policy threw a wrench in the economy’s wheels. Transport gridlocks at sea, land and air makes distribution and production difficult. It is frustratingly difficult to find major inputs such as semiconductors. Also, labor market frictions exist such as recent boosted unemployment benefits or union disputes about vaccine mandates. The result is rising prices independent of demand considerations.

Inflation can be explained with a supply-and demand double whammy. Both stories are not perfect.

The demand side of the equation might show that all the stimulus is not as expansive as they seem. 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.

During the initial stages of the pandemic, money was not particularly scarce. 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 didn’t open liquidity floodgates as some initially believed.

Inflation is clearly being exacerbated by congested production processes and slower distribution. However, this explanation may not be true for all cases. The supply situation varies greatly from one sector to the next. 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. Inflation expectations in the market peaked at mid-November. Bond traders predicted a 2.8 percent annual inflation rate for the next five year as of January. This means that they don’t believe runaway inflation will be our fate. A wise man once stated, “Predictions can be hard especially when it comes to the future.” It will all depend on the Fed’s tightening of policy and how quickly supply constraints can be relaxed.