Before the pandemic, the US averaged an inflation rate of 1.9%. The Federal Reserve Bank (Fed henceforth) considers this rate to be a good target to maintain. This is because at around 2% maximum employment and price stability can be achieved (Summers, Wessel and Murray, 2018). With inflation in the US now averaging 8% (Figure 1), the US is living through one of its toughest economic crises since the 1970s, as the high inflation rate has increased the cost of living by influencing price stability through several channels.
In this paper I posit there are four interdependent reasons causing the recent surge in inflation in the US particularly. The first is the excessive use of fiscal policy. The second is supply bottlenecks. Thirdly, de-anchored expectations. Lastly, wage inflation. Before expounding on my arguments, I introduce the underpinning economic model: the Phillips Curve (PC henceforth). Overall, the period studied ranges from the first quarter of 2020 until before the war in the Ukraine(Q1 2022).
Figure 1: Y-o-Y % change in CPI (Consumer Price Index) for G7 and EU countries. Source: OECD Statistics (2023).
The economic framework that in part underpins central banks’ decisions about inflation is the Phillips curve. Effectively, the original PC embodies the “inverse relationship between wage inflation and unemployment” based on UK data from 1861-1957 (Jorgensen and Lansing, 2019, p.1; Phillips, 1958). While the tradeoff also existed in the US, Phelps (1967) and Friedman (1968) added that agents’ expectations of future inflation regulated their necessity for higher wages, and therefore wage inflation (Burdekin and Burkett, 1988). Furthermore, it is observed that a larger output gap, or a positive difference between actual output and its potential level, is “positively correlated with inflationary pressure” (Occhino, 2019; Fisher, Mahadeva and Whitley, 1997, p.60). This adaptive model is called the expectations-augmented PC (EA-PC henceforth).
However, during and after the Great Recession, inflation did not behave according to the PC. This led economists to believe that the tradeoff between inflation and output embodied by the PC’s slope had weakened or even disappeared. In turn, the idea of a ‘flattening’ PC presupposed that output could be increased at little to no increase in inflation. This conclusion has favored a tendency for looser monetary policy and large fiscal deficits to stimulate the economy after periods of recession in the US ever since (Cerrato and Gitti, 2022; Jorgensen and Lansing, 2019).
In fact, the rise in US inflation experienced today derives from these tendencies. In that, the size of the fiscal stimuli enacted raised aggregate demand above potential output, overheating the economy (Jordà et al., 2022; Reis, 2022b; Summers, Wessel and Murray, 2018). Effectively, Powell (2020) feared that aggregate demand in the country would slump as State-imposed stay-at-home mandates curtailed spending. Admittedly, by April 2020 real GDP had fallen and unemployment had increased by 10 percentage points (see Figure 2) (Bok and Petrosky-Nadeau, 2022; Powell, 2020).
Figure 2:US Quarterly Gross Domestic Product (GDP) [from U.S. Bureau of Economic Analysis (1946)] and Monthly Unemployment levels [from St. Louis Fed (2019)].
To buoy demand, the White House funded five Covid-relief funds over the entire duration of the pandemic through the Fed (Jordà et al., 2022). Cumulatively, these packages provided $900 billion in direct payments into citizens’ bank accounts (USA Spending, 2022). This led to an increase in consumers’ savings and consequently, a boom in spending once businesses reopened. Ultimately, the fiscal stimuli increased actual output above the US’s potential output, leading to a positive output gap (Figure 3).
Figure 3: US Output Gap, % of potential GDP. From Nasdaq Data Link (2020).
Since potential output represents the limit of a country’s productive capacity to meet demand (Central Bank of Ireland, 2014), overshooting that limit leads to overheating in that there is too much money in the economy than what can be bought or produced. In turn, unusable liquidity increases inflation.
Consequently, the sudden increase in consumer spending, or an increase in aggregate demand, needed an equally strong supply chain to match it. However, stay-at-home mandates in most of the manufacturing countries in which goods are made caused supply bottlenecks (Shapiro, 2021).
Thus, by the laws of supply and demand, the longer these delays, and the higher the demand for goods, the higher their prices. As can be seen from Figure 4, after each Covid-relief fund demand-driven inflation rises and so does the supply-driven one.
Figure 4: Contributions to annualized monthly changes in inflation with dated Covid-19 relief plans enacted. Source: Shapiro (2021).
This is because as health mandates forced people within their homes, consumer spending shifted from the tertiary sector to manufactured goods (Shapiro, 2021). Consequently, as manufacturing countries experienced delays in both the production and the shipping of goods, the supply of readily available goods was insufficient to meet the growing demand. Thus, by supply and demand, the ensuing supply chain bottlenecks raise the price of these goods. In fact, Figure 5 shows that spending in the apparel sector, the furniture industry, and food and beverages (I.e., goods) has been the strongest contributor to the rise in CPI inflation since the first half of 2021.
Figure 5: U.S. Consumer Price Index by major groups, January 2021-September 2022. From Veloso and Perroti (2022).
Effectively, the chain reaction described so far appears to be sparked by an increase in savings due to the expansionary fiscal policy enacted. However, the underlying assumption encouraging fiscal policy I.e., that of a flat PC, is inextricably tied to anchored inflation expectations. That is, the EA-PC establishes the strength of the directly proportional relationship between wage inflation and output also based on consumers’ future expectations of the level of inflation. Consequently, if consumers believe that central banks will maintain inflation at its target level in the long run despite spells of higher inflation, I.e., if consumers’ inflation expectations are well ‘anchored’ (Adrian, 2022), then consumers will not change their spending patterns. Therefore, there is reason to believe that any increase in inflation due to a rise in output will eventually be brought back to its target level at no cost. In fact, with inflation in the US averaging 2% for the past twenty years, household and financial market expectations have remained solidly anchored (Reis, 2022b; Jorgensen and Lansing, 2019).
However, the Fed’s overreliance on its track record of anchored expectations misinformed its decision to enact such expansionary policy (King, 2022). Effectively, once fiscal policy increased the price of ‘essential’ household goods, consumers’ expectations de-anchored (Adrian, 2022; Reis, 2022b), nullifying the EA-PC trade off and raising inflation. In fact, recall that based on the EA-PC, any rise in inflation due to an increase in output will be short lived if expectations are anchored. Relying on its track record of anchored expectations, the Fed believed that its new expansionary fiscal policy would achieve its goal of increasing demand at little cost to the economy. However, when the policy increased the price of ‘essential’ categories of goods such as food, clothing, and beverages, through higher demand and supply bottlenecks, it reduced households’ disposable income, and in turn, affected households’ long-term planning of consumption (Ibid.). Research by Reis (2022a) on the Great Inflation of the 1970s shows that when this happens households’ expectations de-anchor. This means that people’s expectations of inflation change to a completely different level from the Fed’s. Currently, the rightward shift in the distribution of households by their expectations of future inflation in Figure 6 shows how most households believe that inflation will rise to 10% in both the short and long term (Adrian, 2022). Conversely, the Fed’s target remains at an average of 2%. The mismatch between expectations is so big to encourage the conclusion that expectations have de-anchored. If so, the tradeoff between inflation and output from the EA-PC does not hold. Therefore, an increase in output is expected to pull up inflation. In fact, despite the harsh reductions in fiscal policy, and a tightening of monetary policy via high interest rate rises (Logan, 2022), the inflation rate keeps increasing.
Figure 6: US households’ 1-year inflation expectations (A) and US 5-year inflation expectations (B). Source: Adrian (2022).
Lastly, the ensuing price changes fueled the tightening of the labor market and induced high wage inflation (International Monetary Fund, 2022; Leigh, Ball and Mishra, 2022). Recall that inflation expectations give signs of having de-anchored. If so, then consumers do not believe that the Fed will be able to reign inflation in. Thus, to counter the rising costs of living, workers will need higher wages.
In turn, higher wages entail higher spending, and therefore, higher inflation. After the pandemic,to kick-start productivity again, firms need more workers. Cumulatively, firms’ demand for labor rose to the point where the Beveridge Curve, i.e., the relationship between the unemployment rate and the vacancy rate, showed a vacancy-to-unemployment ratio of 1.88 (Leigh, Ball and Mishra, 2022). This means that firms are in such high need of laborers that every potential jobseeker can pick between almost two jobs. Thus, workers understand that their bargaining power has significantly increased because of the high demand for labor. To further capitalize on their advantage, workers either quit their jobs en masse or began searching for new employment while employed. This phenomenon has been so influential to be called the Great Resignation (Faccini, Melosi and Miles, 2022). In so doing, competition between firms increased. Consequently, either to keep their contracted workers from being poached, or to hire more laborers, companies have had to increase wages (Ibid.). In fact, hourly wages have increased by 14.4% since 2020. Comparatively, it took eleven years for wages to increase by that magnitude before then (U.S. Bureau of Labor Statistics, 2006). Overall, wage inflation increases salaries, and so encourages more spending. This contributed to the positive output gap seen above.
In conclusion, I investigate four factors behind the sharp rise in US inflation between Covid and the invasion of Ukraine. The first is the excessive use of fiscal policy, which increased aggregate demand until it overshot potential output and led to overheating. Secondly, the effect of supply bottlenecks, which by decreasing supply in a moment of high demand due to expansionary fiscal policy increased inflation. Further, the first two factors increased the price of essential goods to the point where it de-anchored consumers’ expectations. Without anchored expectations, the Fed’s fiscal expansion could not enjoy the tradeoff between high output and low inflation established by the EA-PC, inducing inflation. Lastly, de-anchored expectations and increased labor demand encourage the further tightening of the post-Covid labor market. In turn, laborers exploit their new bargaining power to achieve higher wages, thus raising inflation through higher consumption.
Student at King’s College London
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