For more than a year, policymakers have engaged in wishful thinking on inflation. The March release of the Consumer Price Index, which showed overall prices (“headline” inflation) up 8.5 percent year-over-year and prices, excluding food and energy (“core” inflation), up 6.4 percent, reveals the folly of a policy of inertia and misjudgments.
Inflation began accelerating in March 2021. After abating somewhat in the fall, headline inflation has accelerated since September and has yet to reach a peak. Optimists took comfort in the slowing of the growth of core inflation in the latest report, with accelerating headline inflation driven largely by the increase in fuel prices in response to Russia’s invasion of Ukraine. But even potential stabilization at an inflation rate more than three times the Federal Reserve’s target gives small comfort.
While the Covid-19 recession and subsequent recovery undoubtedly gave rise to unprecedented changes, monetary policymakers have not adapted well. They ignored the signs of a rapidly heating economy, while fiscal policymakers added fuel to the fire. Policymakers have long been focused on a “micro” account of inflation, noting how supply-chain disruptions caused the rise in prices of particular classes of goods (lumber, cars, and so on), rather than noting how these trends were simply the first signs of the broader “macro” trend of a general price increase. The hope throughout most of 2021 was that these special factors would prove transitory, and that inflation would fall on its own without policy intervention. While supply was constrained, expansionary fiscal policy propped up demand. Even as the economy endured the Covid recession, personal income growth increased from 3.5 percent in 2019 to 6.1 percent in 2020 and 7.2 percent in 2021. Federal transfer payments—both through direct payments and enhanced social-insurance benefits, like unemployment insurance—spiked, with transfers accounting for 21.6 percent of income in 2020 and 21.8 percent in 2021.
The combined effects of expansionary fiscal and monetary policy soon became clear. After consumer price inflation began speeding up last March, the labor market rapidly tightened, and by May 2021 job openings outnumbered unemployed workers. By July, this ratio had reached record levels. It has stabilized over the last three months at around 1.8 job openings per unemployed worker. Wage growth, as measured by the Federal Reserve Bank of Atlanta, began accelerating in June 2021 and now stands at 6.0 percent in March 2022. House price growth, as measured by the Case–Shiller index, hit a record 19.8 percent by July 2021. Growth has remained elevated, at 19.2 percent in January 2022.
Policymakers only belatedly came around to recognizing the inflation threat. The Federal Reserve signaled a dramatic change in policy direction in November 2021 with Chairman Powell’s acknowledgement that inflation was not transitory and would require action, but it took the central bank four more months to raise interest rates, and only then by a mere 25 basis points. Meantime, short-term real interest rates have moved further into negative territory, even as long bond yields have increased. Even under the Fed’s optimistic scenario, short-term interest rates will remain below a “neutral” level for at least the next year.
The Biden administration and its allies in Congress have at least sounded the alarm on inflation, though its policy actions—releasing oil from the strategic reserve, berating private companies, loosening gasoline standards—will have essentially zero impact on inflation. At the same time, the administration continues to push for further fiscal expansion. To achieve a meaningful and sustained reduction in inflation will require stronger tightening of monetary conditions by the Federal Reserve, coupled with fiscal restraint that so far has been lacking.
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