Society problems

Taming Inflation: What Policymakers Can – and Should – Do

by DOUGLAS HOLTZ-EAKIN

The shocking acceleration of inflation is the economic signature of 2021. In January, year-on-year consumer price index (CPI) inflation was 1.4%; by December, it had risen to 7.0%. Most strikingly, prices for food, energy and housing – which make up more than 50% of the typical family budget – soared 8.2%.

The 5.7 percentage point 12-month jump in CPI inflation was exceeded only twice in the post-war period: in 1951 it jumped 10.6 percentage points and in 1974, it increased by 6.1 percentage points. Both episodes are instructive.

The 1951 episode is a cautionary tale of overstimulation of the economy. In this case, year-over-year growth in gross domestic product entered the year into double-digit territory and Korean War-related defense production came on top of growth in year-on-year government spending that peaked at 49% in the third quarter. Lesson: Excessive government spending in a booming economy can quickly fuel inflation.

On the other hand, the 1974 episode demonstrates exactly the opposite of stimulating demand. Instead, it presents a huge supply cost shock – the quadrupling of oil prices due to the OPEC oil embargo. Lesson: Cost increases borne by supply problems can be quickly passed on to consumers, even if the economy is heading into recession.

Perhaps the best we can hope for from policymakers is that they stop making the problem worse with massive new spending bills, such as the Build Back Better Act.

2021 inflation reflects a combination of these forces. The COVID-19 pandemic has wreaked havoc on labor markets around the world, and the resulting disruptions to supply chains and the production of goods have been well documented. These supply constraints have increased costs and generated higher inflation worldwide. Consumer price inflation in Europe, for example, increased by around one percentage point each quarter and ended 2021 at 4%. Part of the US experience is also driven by supply chain issues.

But the U.S. government added fuel to the fire by passing the $1.9 trillion deficit-funded U.S. bailout in March 2021. At the time of its signing, the U.S. economy was growing at a blistering pace 6.5%; an additional stimulus was neither necessary nor desirable. Inflation reacted immediately to the policy error, rising from 1.9% in the first quarter to 4.8% in the second quarter, almost three times the increase in supply-driven inflation in Europe . Fiscal stimulus was bolstered by an aggressively accommodative monetary policy that featured zero percent interest rates and continued large monetary injections. Inflation continued to rise as the year progressed.

Inflation is clearly a problem in the present. Will this continue? To be sustainable, price inflation must be accompanied by wage inflation and higher inflation expectations. Wage inflation has already arrived, with the average hourly wage increasing by 5% from December 2020 to December 2021. To make matters worse, consumer expectations for inflation over the next year have risen from 3 % to 6% in 2021. This raises the specter of worker bargaining. for higher wages as a hedge against expected inflation. When these increases in labor costs are passed on to consumers, expected inflation becomes a self-fulfilling prophecy.

What should decision makers do?

Diagnosing the roots of this inflation means identifying the appropriate policy response. Ultimately, supply chain issues come down to the impact of the coronavirus. This is better compensated by a more effective public health policy. Both administrations have botched the COVID-19 response by relying on vaccines as a silver bullet. It is not surprising that, as The New York Times reported, six former Biden transition advisers called on the president “to adopt an all-new national pandemic strategy focused on the ‘new normal’ of living with the virus indefinitely, not eliminating it.”

The Federal Reserve…needs to lift its foot off the monetary accelerator and begin to brake with higher interest rates and withdrawals from the massive monetary injection undertaken during the pandemic.

Such a strategy would be comprised of a wider range of pandemic responses, with more emphasis on testing and therapeutics, and less on containment, vaccine and mask mandates.

There are, of course, traditional economic policy tools available to slow the excess stimulus that contributes to inflation. However, it is highly unlikely that policymakers will soon embark on structural deficit reduction via higher taxes and lower spending. Perhaps the best we can hope for from policymakers is that they stop making the problem worse with massive new spending bills, such as the Build Back Better Act.

The focus, therefore, is on the Federal Reserve, which needs to take its foot off the monetary accelerator and begin to brake with higher interest rates and withdrawals from the massive monetary injection undertaken during the pandemic. If it taps too lightly, inflation will persist and take root. If it gets too aggressive – as it usually did in its post-war response to sharp increases in inflation – growth will stall and a recession could ensue.

Inflation is the main economic problem this year, but it is largely attributable to Washington’s policy mistakes over the past year. Policymakers will need to up their game in 2022 to get inflation under control without hurting the recovery.

Douglas Holtz-Eakin is the president of the American Action Forum.

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