Inflation

Who is to blame and what is to be done?

Today’s post contains more than the usual number of links to secondary sources and so you might find that Gmail has cut some of my content or truncated this post. I apologize for this. There is one link that I want to make sure you see, however, which is to the Saturday Night Live episode featuring Jimmy Carter’s Inflation Message, which you can find here. Inflation is a serious matter, of course, but sometimes you’ve just got to laugh.

I have now relocated for the summer to Martha’s Vineyard, where gas prices are approaching $6 a gallon and food prices are out of sight even by Vineyard standards. Nationally, the average gas price is now close to $5 a gallon, up $2 or so from a year ago. I filled up my tank earlier this week, depleting even further what is left of my shrinking retirement fund after this year’s equity market rout. And so I will ask the $20 trillion dollar question which seems to be on everyone’s mind. This no longer “Why didn’t I sell all my equities last year?”. It is now “Who is to blame for US inflation and what is to be done about it?”.

This is a two-part question, and the most important part is the second one: “What is to be done”. But human nature being what it is, all anyone seems to be talking about these days is whom to blame. And this is particularly true in Washington DC, where the blame game remains a favorite pastime among politicians and the chattering classes. And you have to admit that pounding your political opponents on social media about their failures on the inflation front is probably a lot more rewarding than watching the Nats lose yet again in that other national pastime.

Inflation is a real problem for real people, however, and it can be devastating in its consequences, particularly for lower and middle-income families. Median family (household) income in the US is now about $68,000 and only 5% or so of households have incomes higher than $200,000. But even some folks in the top 5% are having a tougher time making ends meet due to rapidly rising prices. Inflation presents serious economic challenges for a large swath of the population, it disrupts financial markets and the real economy in complex and pernicious ways, and it can quickly become endemic if not dealt with promptly and decisively. And so as a nation we need to find effective solutions to the inflation problem, and we need to implement them as soon as possible. Time is not our friend here.

Before we end the blame game and move on the question of inflation’s causes and solutions, however, let me ask the obvious question: Who do most Americans blame for today’s inflation? No, not Vladimir Putin, Xi Jinping, Saudi Crown Prince MBS or even Jay Powell for that matter. Why it’s President Biden of course. And increasingly opposition politicians are targeting Janet Yellen, the Biden Administration’s Treasury Secretary (and a former Fed Chair). Dr. Yellen spent most of the past two days testifying before Congress, where she got grilled on inflation by Republican Representatives and Senators. Under the circumstances, she probably wished she had gone to the Nats game instead. And perhaps so does her boss, based on some recent press reports of Yellen’s initial skepticism about the inflationary risks of Biden’s covid spending (which she has denied).

We should not be surprised that people blame President Biden for the current condition of the US economy. He is after all the duly elected President of the United States. (Yes, “duly elected”.) And as POTUS, Biden sits atop the executive branch of what we like to say is the most powerful country in the world, or at least the country with the largest and most valuable economy. So presumably someone in his position must be able to do SOMETHING about the rising price of gas, food and most everything else. Right?

Well, yes and no. The President of the United States has truly awesome authority and power, with his finger on the nuclear button and all that. And with a cooperative Congress the President can indeed exercise significant influence over the state of the economy, particularly through the impact of fiscal policy (taxation and government spending). But as we know from history, fiscal policy implementation requires cooperation between the executive and legislative branches and a shared view of policy ends and means, which is clearly not the case today. And as we know from history, it is generally a lot easier to pass fiscal stimulus (tax cuts and spending increases) than it is to tighten fiscal policy (raising taxes and cutting spending).

And so we see that while fiscal policy can be successfully employed to stimulate the economy and drive economic growth, the tougher job of tightening policy and taking away the punch bowl generally falls to the Fed. Unfortunately, however, the Fed doesn’t always get to the punch bowl in time, and the party does sometimes get a bit out of control. And the hangovers can be quite bad, and long lasting.

For a good historical example of this we can look at the 1960’s. Early in the decade, Presidents Kennedy and Johnson aggressively employed Keynesian fiscal policy to stimulate the economy, with both tax cuts and deficit spending targeted to increase economic growth and reduce unemployment. Things got out of hand, however, when President Johnson and a Democratic Congress decided that they wanted both guns and butter and simultaneously ramped up deficit spending on the Vietnam War and LBJ’s Great Society programs. Inflation, which had been well contained until then, increased from 1% in 1965 to 6% by the end of the decade, and this laid the foundation for even higher inflation to come in the following decade.

Although US inflation in the late 1960s is generally attributed to LBJ’s out-of-control deficit spending, it is also true that the Fed failed repeatedly over the decade to tighten monetary policy in time to offset this excessive fiscal stimulus, a failure acknowledged with deep regret in 1970 by outgoing Fed Chair William McChesney Martin. (Bill Martin was an English and Latin major at Yale, whose father helped draft the Federal Reserve Act in 1913. Martin was the longest serving Fed Chair in history, serving almost 19 years, from 1951-70, longer by 131 days than his only close competitor, Alan Greenspan, who served from 1987-2006.) And the failure of the Fed under Martin’s leadership to tighten monetary policy preemptively in the face of strong political pressure from the Johnson administration left the US economy in a vulnerable and precarious position going into the 1970s, a failure which turned out to have serious consequences.

Although the economic history of the 1960s has clear parallels with our current situation—a big bout of fiscal stimulus and a long-dovish Fed—it is the 1970s that many contemporary pundits cite as the more pertinent precedent. During the 1970s, the US and global economies were hit with two major energy (oil) crises, in 1973 following the Yom Kippur War and in 1979 following the Iranian Revolution. And this happened at a time when the global and US economies were much more energy intensive than is the case today. During the 1970s, the price of gasoline in the US more than tripled and peaked at around $1.20 per gallon in nominal terms, equivalent to $4.20 today (about 15% below the current national average). The 1970s oil crises have clear parallels to today, of course, with global oil and gas (and food) prices rising to record levels following Russia’s invasion of Ukraine. And so we see that exogenous events, most notably unexpected geo-political events, can have a big impact on the condition of the global economy and the rate of inflation. This happened in the 1970s and it is happening again today.

Unfortunately, the 1970s turned out to be a decade not only of “inflation” but of “stagflation”, with a stagnant economy, high unemployment and high inflation. Those of you who studied the Phillips Curve in your introductory macro-economics class may recall that it describes the inverse relationship between inflation and unemployment, variously defined. But this relationship is more complex than simply “unemployment down, inflation up (and vice versa). The relationship between economic growth, employment and inflation is a complex and dynamic one, which is not linear and which changes over time. Despite rumors to the contrary, the Phillips Curve is not dead, but it was quiescent for a long period of time, which may have lulled economic policymakers into a false sense of confidence regarding the inflationary consequences of too much stimulus. As we are seeing today.

OK, enough with today’s history lesson. Now back to my opening questions. Who is to blame for inflation and what is to be done?

As usual, I prefer to ask questions rather than to answer them, but here are a few thoughts for your consideration:

What do we mean by “inflation”? I started this post with a comment about gas prices and the cost of living here on Martha’s Vineyard. But high prices are not the same thing as rising prices, and neither is increase in the price of selected items (like gasoline). So what is inflation? Inflation is the increase in the prices of goods and services over time. Inflation cannot be measured by an increase in the cost of one product or service (gas), or even several products or services (gas, food and airplane travel). Rather, inflation is a general increase in the overall price level of the goods and services in the economy, as measured by various indices (the Consumer Price Index (CPI) being the most widely followed.) Of course the price of gas, food and transportation all factor into the overall price level and so contribute to inflation. But in the public mind, “inflation” often equates to “high prices” (rather than rising prices) and this sometimes muddies the discussion. Inflation and the level of prices are related but distinct concepts, and we should be careful in how we use the two terms.

We are where we are. Where we find ourselves today is not a great place to be economically, however we got here and whoever is to blame. But things could be a lot worse. The economic situation today is not nearly as bad as some like to portray (often talking their own book as it were). And it is certainly not as bad as it was back in the 1970s, with double digit rates of both inflation and unemployment. (Interest rates were also in the double digits. My first home mortgage in 1981 was at 13.5%.) Compared to the 1970s, inflation expectations today are less deeply entrenched (although rising), the economy is less energy intensive (although still too dependent on fossil fuels) and regulated financial institutions are well capitalized (although this is less true in the the shadow banking system).

The US economy has recovered quite strongly from the covid pandemic—more so than many experts thought possible at the time, and perhaps more quickly than was optimal—thanks in large part to low interest rates and massive amounts of fiscal stimulus. And this means that millions of formerly unemployed Americans now have jobs, with rising pay and benefits, even if a surprising number of working age adults continue to sit things out for a while longer. But we continue to suffer from serious supply chain issues, labor shortages and now rapidly rising prices. Now may be a good time to look for work, but it is not a particularly good time to buy a house, refurbish a kitchen, or find someone to fix that leaky sink (certainly not here on MV). And while it is great to be employed and getting pay raises once again, putting food on the table and gas in the tank remains a challenge for too many Americans. And as prices rise, it is becoming more difficult by the day.

It is possible that US inflation may already have peaked, but this is far from clear. And even if the rate of inflation has peaked, this doesn’t mean that prices are coming down; they will just be rising more slowly. And of course it is quite possible that economic growth will soon slow as well, increasing the odds of recession over the coming year(s).

Acknowledge mistakes and move on. It now seems likely that President Biden’s signature covid relief package, the American Rescue Plan, may have contributed significantly to the bout of inflation that we are currently experiencing. Some prominent Democratic economists, most notably Larry Summers, warned at the time that passage of the ARP risked over-stimulating the US economy, and many of those who supported the ARP more fulsomely, like Paul Krugman, now acknowledge that in hindsight the amount of stimulus embedded in the ARP was perhaps larger than it needed to be. And in fairness, these were points often made by Republicans in Congress, although their motives in doing so were sometimes suspect.

Having said that, the ARP was certainly not the sole driver of today’s inflation and it may not have been the primary one either. Passage of the ARP in the US does not explain why other countries which employed much less fiscal stimulus in response to covid are also now facing inflation rates comparable to the US. And the fact that the ARP may have contributed to rising inflation in the US does not mean that this legislation was entirely ill-advised from the get go. Controlling inflation is not the sole or even the primary goal in formulating economic policy. Many other things matter, such as stimulating full employment, promoting clean energy and addressing economic inequality. The ARP was passed at a time (early 2021) when the US and global economies were still very fragile, the course of the pandemic was highly uncertain and the risk of policy inaction was arguably skewed to the downside (with more risk from failing to act than from acting too boldly). And so the ARP seemed to many at the time like a reasonable policy, even a prudent one perhaps.

In any event, I see no good reason for Biden and the Democrats to continue acting defensively about the ARP. What has been done is done. The ARP was not a perfect bill, and in hindsight it may have been too large, but it was a well intentioned response to an unprecedented pandemic affecting hundreds of millions of Americans. And there are worse things to do than occasionally putting some money into the pockets of your most vulnerable citizens when times are really tough through no fault of their own.

The Biden Administration was not the only party to make mistakes in responding to covid, of course, and we should not forget what a mess Biden inherited when he took office in late January 2021. So some of the blame for our current situation must lie with those who came before and laid the groundwork.

The Fed also made some serious mistakes along the way, persisting for perhaps too long in the view that inflation would prove to be “transitory”. Until recently, the prevailing view at the Fed, and in much of the economic policy world, was that when (not if) global supply chain constraints loosened up in a post-covid world, the rate of inflation and perhaps even the level of prices would come down and might do so quickly. But the Fed has now expressly disowned its “transitory” language and has begun raising rates aggressively. It is very unclear to me what if any impact an earlier tightening might have had on today’s inflation rate, but I think we should not overstate the likely impact of a few months delay.

And of course the Fed has been widely criticized (as have other central banks) for its program of Quantitative Easing, which increased the size of the Fed’s balance sheet by $8 trillion cumulatively ($20+ trillion globally) since the financial crisis. QE is a widely misunderstood topic, which I will write more about later. For now, however, let me just point out that QE seems to have had its intended effect of driving down long-term rates in the UST and mortgage markets with little apparent impact on inflation until recently, as banks were reluctant to lend and consumers and businesses to borrow for many years following the financial crisis (and in the early days of covid). The excess reserves created by QE largely sat on deposit at the Fed (earning interest) for much of this period, and so did not immediately expand the supply of credit to the economy. This has now changed, however, and so I think it is fair to say that QE may also be one of the big contributors to today’s inflation, but perhaps not in the simplistic way that many think (QE = increase in money supply = inflation).

Inflation is not solely a US problem. This obvious point is too often lost in the US media coverage and what passes for political discourse in this country. The US did not create today’s inflation problem and export it to the rest of the world, as we arguably did with sub-prime mortgage bonds in the 2008 financial crisis. And the US is not the only country suffering from rising inflation, far from it. Inflation is now a problem in most of the rest of the world and so we are all in this mess together. Bank of England Governor Andrew Bailey recently testified to Parliament that the UK is facing an “apocalyptic” increase in food prices, which he attributed to Russia’s invasion of Ukraine. Rising food (or gas) prices is not the same thing as rising inflation, of course, but food and gas are important components of consumer spending which can quickly filter through into broader indices of the cost of living. And Governor Bailey’s comment is particularly noteworthy, if only because “apocalyptic” is not the sort of adjective one normally hears used by central bankers.

Interest rates may have much further to rise. Following the 2008 financial crisis, central banks across the world slashed interest rates to 0% (or below) and engaged in large amounts of quantitative easing (buying government bonds and other securities with newly created reserves, to drive down long-term rates). And when covid hit in early 2020, they did it again. The world’s major central banks are now in various stages of tightening monetary policy, driving up short-term interest rates and shrinking their balance sheets. In the US, ten-year UST bonds now yield about 3% and the Fed Funds rate is at 1%. But if inflation doesn’t respond quickly, rates could go up faster and further than is currently expected. The Fed Funds rate was at 2.40% back in July 2019 (pre-covid) and it was at 5.25% in May 2007 (before the financial crisis fully hit). Will we see a 5% Fed Funds rate any time soon? Probably not, but we could well see it hit 3.5% or higher by the end of next year. (The latest Fed forecasts indicate a median expectation of 2.9% by the end of 2022.)

No more WIN buttons, or wage-price controls. The track record of US presidents attempting to deal with runaway inflation is not a good one. President Nixon imposed disastrous wage and price controls and cut the national speed limit to 55mph, which prompted one Texas wag to reply “If you are driving 55 mph in Texas, you’d better be driving on the shoulder”. Nixon’s successor, Gerald Ford, called inflation “Public Enemy Number One” and minted his now (and even then) infamous WIN buttons. [WIN stands for Whip Inflation Now.] And Jimmy Carter called for a period of “national austerity” and asked Americans with the arrival of cold weather to turn down their thermostats and put on a sweater (as he was wont to do, even in the Oval Office). Suffice it to say that none of these presidential strategies was successful economically or from a PR perspective. But some of them did provide great content for comedians, as with this must-watch Saturday Night Live sketch on President Carter’s Inflation Message (1978). (You can watch the actual broadcast here.)

Let the Fed do its job. One helpful thing which Biden can NOT do, however, is pressure the Fed to adopt monetary policies which the Administration thinks might be helpful to the Democratic Party in the run-up to mid-term elections this November. This is the mistake made by Presidents Johnson, Nixon and Trump, which is not a group Biden should want to be associated with. (Trump went so far as to call the FOMC members “boneheads” for refusing to cut rates to help him win reelection.) The Fed’s monetary policy independence is a critically important feature of our central banking system, more firmly established than that in some other countries, but its survival depends on the deference shown it by politicians and the willingness of the Fed to speak truth to power, neither of which has always been the case. And so Biden should resist the urge to meddle in the Fed’s decision making, whatever the consequences. Fortunately President Biden and his team seem to understand and accept this, as evidenced by their continued silence on Fed monetary policy and Biden’s decision last November to reappoint Jay Powell as Fed Chair .

And the Fed now seems to be on the case, even if it was perhaps a few months late to start tightening. The Fed has started raising short-terms policy rates and will soon begin shrinking its balance sheet and it has provided clear forward guidance to let the market know what it is up to, as reflected in the latest FOMC’s statement (link below).

Hope for the best, prepare for the worst and do your job. Things do not look very good politically for the Democrats as we approach the mid-term elections in November, according to recent polls and surveys. If things don’t improve quickly on the inflation front—which they almost certainly will not—the Dems may suffer big losses in both the House and the Senate. I don’t know if this is right or not—the pundits and pollsters are often wrong—but I would hope the Biden Administration can continue to resist the urge to let near-term election pressure drive their economic policy (as they have so far).

The US economy is still very strong by most accounts, with record low unemployment and significant wage growth starting to kick in. But this may not last much longer if we don’t get inflation under control, as high prices begin to impact economic activity. We don’t yet have stagflation, as we did in the 1970s, but we may soon be approaching another recession , which will not be a good thing for the Democrats, or any of us, as we approach the next general election in 2024.

No one knows what will happen with inflation and the economy between now and the mid-terms, but there is not a lot more that the Biden Administration can do about it at this point. Which is all the more reason to leave the spotlight on the Fed, let the FOMC do its job and hope they are successful. The Fed Board isn’t up for reelection this November, and they can take the political heat. And the Biden Administration should let them.

Links:

The Biden Covid Stimulus Plan is Big and Bold, but it has Risks, Washington Post, February 4, 2021

Look at 1960s, not 1970s, to Learn How Inflation Took Off, David Marsh OMFIF, November 22, 2021

What Jerome Powell Couldn’t Say in his Speech and Couldn’t Know, WSJ, December 2, 2021

FOMC Policy Statement, May 4, 2022

Fed Chair Says Fed Could Have Raised Rates Sooner, Washington Post, May 12, 2022

Powell Admires Volcker. He May Have to Act like Him. NY Times. May 14, 2022.

Fed’s Brainard Says It’s Too Soon to Say if Rate Increases Can Slow, WSJ, June 2, 2022

The Perverse Politics of Inflation, Paul Krugman, NY Times, June 2, 2022

America’s Next Recession, The Economist, June 4, 2022

Democrats are Working Through the Five Stages of Inflation Grief, Washington Post, June 7, 2022

Yellen Tells Lawmakers She Expects Inflation to Remain High, WSJ, June 7, 2022