Inflation is near a forty-year high, and unemployment is near a fifty-year low. For months, experts have debated why inflation is high and what to do about it. These questions are the topic of my opinion piece for The Economist. In a nutshell, the causes of high inflation are complex. While the fiscal policy is only one of many contributing factors, I discuss how tying relief to economic conditions, not political motives, would help us do better in the next crisis.
Please read the entire piece. Note, subscriptions to The Economist are well worth it. Their articles were my introduction to economics in college. You see where that led.
Today’s post gives a thumbnail of my arguments and links to some related research. Remember that we are in the early stages of the research, and while I share high-quality analysis, it’s too soon to say anything confidently. (Honestly, we will never know how much any factor added to inflation. Welcome to macro!)
THE PAST few years have once again demonstrated that blunt tools—such as the government sending out cheques and pushing down interest rates—affect how much consumers and businesses spend. But it is difficult to fine-tune such policies without the benefit of hindsight. Even after the fact, it can be hard to analyse what should have been done. Inflation was not transitory, but neither was covid-19. And the stresses the pandemic put on the global economy were far-reaching. What does that mean for policy design in the future?
Ok, so what’s up with inflation? There’s a range of likely causes. And how they interact is important too. Note, I focus on inflation, excluding food and energy.
Covid-19 is the root of all evil, including for inflation.
In addition to killing and disabling millions of people worldwide, the pandemic upended our economic lives. Even with an effective vaccine, we have not been able to contain it. Delta and Omicron variants, including new ones now, are tragic reminders.
The list of economic disruptions due to Covid is long: supply chains, goods production, workers dropping out of the labor market, consumers shifting from services to goods, and geographic mobility straining housing markets.
The effects of geographic mobility due to the ability to telework have gotten relatively little attention. Research by John Mondragon and Johannes Wieland suggests that it could be an important factor behind rising housing costs.
Fiscal and monetary policy was a big boost to demand, pushing up inflation.
Stimulus is another source of inflation. I was a proponent of the Rescue Plan at the time, with its $1,400 checks and the extra $300 per week in jobless benefits. I remain one, even with the higher inflation. Why? The rapid recovery in the labor market.
I acknowledge that the stimulus caused some inflation, which is a hardship for many families. It’s also an example of where the interactions were problematic. Due to the pandemic, consumers shifted from services to goods, but supply chain and other production problems limited the supply of goods. The shift to services and the healing of supply chains took longer than expected. So the stimulus goosed demand for goods (my research on the $1,400 stimulus checks confirms that) exactly when supply was constrained. More demand and less supply lead to inflation.
But how big was the effect? The research so far comes to different conclusions. For example, here are two papers from economists at the San Franciso Fed.
The first says Rescue Plan added 3 percentage points to inflation, which is basically the entire bump up in core inflation:
The second says it added 0.3 percentage point, which is not much:
Something for everyone here. When faced with such differences of opinion at the Fed, we applied the ‘Slifman rule.’ Take the average. :-) In fact, my prior had been about 1.5 percentage points. Substantial, but not the whole story.
How to do better in the next recession?
We will debate the effects of the Rescue Plan forever, yet we can all agree that it’s possible to do better next time. My piece discusses one idea:
So, what is the lesson for next time? A smaller fiscal response? Not necessarily. I have written extensively on the need for stronger automatic stabilisers—stimulus that is distributed when economic conditions deteriorate. For example, direct payments to households or extra jobless benefits could kick in when the unemployment rate rises. After the experience of the pandemic, I am even more convinced that this approach is critical. Congress passing these programmes ahead of time will commit them to building the delivery systems before the crisis; jobless benefits are in particular need of modernisation.
I am a firm believer in more automatic stabilizers. And this crisis strengthened my conviction. Here’s me talking about the policy:
The basic approach is simple: when the Sahm rule triggers, it’s time to send out stimulus checks and ramp up jobless benefits. The policy response is agreed to ahead of time and tied to economic conditions. How to tapering off the relief needs more analysis, especially in a recovery like this one where supply is constrained. We can do better on the size and timing—a question that will keep me busy for some time.
The current recovery is halfway to the finish line. The goal now is to get inflation down while keeping unemployment low. It’s not going to be easy, and frankly, outside the United States, it will be even harder, but there is a path to a full recovery.
That said, we can do better next time. In this crisis, we applied many lessons learned from the Great Recession. And that should be our goal in the next one too. Automatic stabilizers are one of many possible improvements. More effective administrative systems are also critical. It would be time better spent preparing for next time than to Monday morning quarterback the Rescue Plan.
Best of all would be for economic advisers to focus now on ideas for Congress and the White House to get inflation down, especially food and energy prices. The Fed can cool demand, but it cannot boost supply. We need more supply! That’s Congress. That’s the White House. Do something and do it now!
Please consider financially supporting my Substack with a paid subscription. You will help me to write regularly about economic policy. You will also receive some paid-only posts.
The Sahm rule would be great except we have a whole political party devoted to eliminating the "undeserving poor" rather than providing for their basic protection and human needs. There are also lots of new data that basic cash income is more effective than agency programs in promoting quality of life for poor families. Have you considered that in the back room the ARP was designed mainly to prevent food riots on the streets of America?
It's funny how you frame the Covid sentences without pointing out the accountability. It is specific policies in response to Covid that caused the downturn. You are stating it like all policies were automatic consequences of Covid as if there were no choices and better thought out alternatives. This avoids dealing with the policy maker's accountability.
It was clear when Delta came that the available vaccines wouldn't be able to stop the spread. This changed what is possible to achieve, and trying to do what is impossible always has a cost.
Not being able to scrutinize such mistakes of the past sets the stage for future misjudgment, without accountability.