Although US monetary policy was too aggressive for too long, the likely culprit for the recent rise in consumer prices was an extraordinarily easy fiscal policy. After all, the Great Recession was also met with an aggressive monetary policy response, but inflation barely budged for a decade.
CAMBRIDGE – In considering what caused the sharp increase in the rate of inflation in the United States from the end of 2020 to the present day, my initial instinct was to focus on aggressive monetary policy, following Milton Friedman’s famous statement that “ inflation is always and everywhere a monetary phenomenon.” But while monetary policy is important, aggressive fiscal policy may have been more important this time.
From March 2020 to March 2022, the US Federal Reserve held short-term nominal interest rates at zero, while using quantitative easing to expand its balance sheet from $4 trillion to eventually $9 trillion. Today there is a general consensus that the Fed was far behind after the end of 2020, if not sooner. Since he did not raise his policy rate until the spring of 2022, he failed to keep nominal interest rates above inflation and thus lost control.
The problem with saying that monetary policy was the sole cause of recent inflation is that the Fed was just as aggressive during the Great Recession and its aftermath, from 2008 onwards. Short-term nominal interest rates were set at zero for what turned out to be a seven-year period (beginning of 2009 through the end of 2015). The Fed’s balance sheet grew from $900 billion in August 2008 to more than $4 trillion – which seemed like a hefty figure at the time. However, inflation remained subdued – averaging around 2% per year from 2009 to 2019 – and inflation expectations remained anchored at roughly the same value.
Why were the inflation results so different from 2020 onwards? One obvious difference between the two periods is the drastic fiscal expansion that began in the spring of 2020 in response to the Covid-related recession and included federal transfers that dwarfed those associated with the Great Recession.
To see how fiscal expansion translates into inflation, let’s start with the volume of federal spending since the second quarter of 2020. Quarterly data through the first quarter of 2022 demonstrate a cumulative excess of federal spending (above baseline spending). precovid of 5 billion dollars per year) of 4.1 billion dollars -or 18% of GDP in 2021-. The main increases in spending (at annual rates) reflect disbursements of 9 trillion dollars in the second quarter of 2020 and 7 trillion dollars in the third quarter of the same year, during the administration of Donald Trump, followed by 8 trillion dollars in the first quarter and in the second quarter respectively of 2021, already in the government of President Joe Biden.
To assess how inflation responded to this spending, I relied on “price level fiscal theory,” which has been developed in research by John H. Cochrane of the Hoover Institution. Suppose the government does not plan to finance any percentage of its additional spending by cutting spending or raising taxes. If there is no formal default on Treasury bonds, the “income” must come from inflation above the normal or expected level, which in turn reduces the real (inflation-adjusted) value of outstanding government bonds. Specifically, inflation above 2% per year since mid-2020 can be expected to accumulate into an unexpected rise in the price level, and this accumulation of excess consumer price inflation between May 2020 and July 2022 turns out to be about 11%.
The net public debt in nominal terms corresponds approximately to the part of the public debt, which was 21 trillion dollars in mid-2020 –or 91% of GDP in 2021-. This item subtracts from gross debt the amounts held by trust funds and federal agencies but not the portions held by the Fed—which is reasonable because the Fed’s Treasury and mortgage-backed securities holdings are more or less offset. by the Fed’s nominal liabilities. (You could also adjust for federal debt that is CPI-indexed, but this amount barely represents around 7% of the total).
The unexpected 11% increase in the price level reduced the real value of the net public debt by $2.3 trillion (equivalent to an 11% default on the debt), which translates into effective revenue for the federal government. (Because the increase in the price level was a surprise, it should not have affected the nominal interest rates that the government had to pay on its bonds.)
To pay off the full $4.1 trillion of excess spending, the unexpected rise in the price level needs to be higher: in the range of 19%, rather than 11% (although even this higher figure assumes, perhaps too optimism, that the government will not have more spending hikes in the future). As of July 2022, the required price level accommodation can be achieved with 9.4% inflation over one year, 5.7% average inflation over two years, or 3.5% average inflation over five years.
All of these intervals are followed by 2% inflation. The five-year result is not too far from the current bond market implied inflation rate over a five-year horizon. That is, the fiscal strategy is consistent with the expected inflation rates inferred from the five-year yields on conventional and indexed Treasury bonds.
In this way, a plausible argument is that the increase in federal spending triggered by the Covid-19 crisis led to a permanent and unexpected increase in the price level of around 19%. This increase in the price level is a mechanism to finance additional spending related to covid. In a reasonable scenario, the CPI inflation rate declines fairly quickly from its current level of 8.5% and averages around 3.5% over the next five years. Although the rate of inflation eventually returns to 2%, the rise in the price level is permanent.
The bottom line is that while monetary policy was too aggressive for too long, the main culprit for recent high inflation is likely to have been extraordinarily expansionary fiscal policy.
Robert J. Barro, Professor of Economics at Harvard University, is a Nonresident Senior Fellow at the American Institute of Business and a Research Associate at the National Bureau of Economic Research.
Copyright: Project Syndicate, 1995 – 2022
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