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Inflation: A Brief Look Back, and A Path Forward

The latest report continues this trend. It shows that the monthly CPI increased 0.9 percent in October, and the CPI rose 6.2 percent for the 12 months ending in October, the largest 12-month increase since the period ending November 1990.

Naturally, these price increases have many consumers worried, and it is not at all surprising that the latest CPI report prompted President Biden to respond that “Inflation hurts Americans’ pocketbooks, and reversing this trend is a top priority for me.” It is also not shocking that many people have been blaming the Federal Reserve for the price surge and clamoring for the Fed to tighten its policy stance to get inflation under control. Often it seems as though blaming the Fed for inflation—especially if they “printed too much money”—is practically a national pastime. (One former Federal Reserve economist accuses the Fed of being in denial and thinks that the central bank should have already started tightening its policy stance.)

In contrast, I have been urging caution, warning against the damaging effects of a prematurely tight monetary policy. The reason for this view rests on the underlying cause of the recent episode of inflation: unprecedented economic disruptions caused by the COVID-19 pandemic and the government’s responses. The pandemic (and the government shutdowns) caused unusually large and rapid swings in demand, as well as disruptions in the ability to supply goods and services.

Aside from the technical implications that these recent supply shocks have for an inflation-targeting central bank such as the Federal Reserve (which I’ll address below), these disruptions serve as a stark reminder that policymakers will not reverse the recent CPI surge unless their policies address the underlying causes of rising prices. This direct connection is why I have been arguing for targeted policies to lower price pressures, and against both profligate fiscal expenditures and prematurely tight monetary policy.

Nothing in the latest CPI report changes my policy prescription.

For the past several months, as demand has picked up, supply problems in a limited number of goods categories—which happen to be highly visible in consumer markets—have been responsible for the bulk of the increase in the CPI. In October, just three categories of goods are responsible for 46 percent of the overall CPI increase (food at 12 percent, gasoline at 22 percent, and used cars & trucks at 12 percent). Within the food category, the largest increases have been in several beef, pork, and poultry products. Rent accounts for another 19 percent of the overall increase, so just four categories explain almost two-thirds of the overall increase. (During most of the past 6 months, abnormally large relative price movements for a handful of goods have resulted in above-average changes in the overall CPI.)

Suppliers of most of these goods were heavily disrupted during COVID-19, both because of the virus itself and the government’s responses. There are also many long-standing regulatory/policy problems that have exacerbated the COVID-19 supply shocks, including restrictive labor, immigration, and trade policies. Policy responses to these supply shocks will be ineffective if they fail to directly address these problems, and they will be counterproductive unless they recognize that the economy is not in a typical demand-driven downturn.

Here is a brief rundown of what I (and a few others) have been saying about this episode of inflation, and what policymakers should do about it.

  • The current economic shock has a clear cause: the global COVID-19 pandemic and the corresponding government responses. Protective measures (such as quarantines) and shutdown orders resulted in major disruptions, including the ability of people to work and, especially in the hospitality and travel industries, the loss of customers. Some of these disruptions appeared as a massive decrease in consumer demand—people were buying fewer goods and services relative to what they had purchased prior to the pandemic.
  • In March, April, and May of 2020, the monthly CPI declined. In April, May, and June 2020, the annual CPI changes were 0.2 percent, 0.3 percent, and 0.7 percent, respectively, well below average. The CPI was essentially on a downward trend through October 2020. (Although most are quick to blame the Federal Reserve for the recent CPI increases, few, if any, praised the Fed for those price declines.) Between the fourth quarter of 2019 and the second quarter of 2020, nominal gross domestic product (NGDP) fell from $21.7 trillion to $19.5 trillion, a rapid decline of economic activity that surpasses anything in the historical record.
  • As governments began lifting pandemic-related restrictions, and a larger portion of the population received COVID-19 vaccines, businesses began reopening and consumer demand rapidly increased. From the second quarter of 2020 to the fourth quarter of 2020, GDP increased by 10.27 percent, the largest two-quarter increase in the historical record. (A 10.18 percent increase was recorded in 1950.) From the fourth quarter of 2020 to the third quarter of 2021, GDP grew by 8 percent. Yet, the pandemic was not over, and many businesses were unable to supply the consumer goods necessary to meet demand.
  • Given the nature of the economic shock from the pandemic and the government shutdowns, there is no reason to expect a one-for-one return of the CPI to its previous path. Put differently, there is no reason for the CPI to increase in 2021 by the same percentage that it fell in 2020. Nor is there any reason to expect the CPI to increase at the same rate it declined in 2020—no federal agency (or Congress) has such control over changes in the price level or the aggregate economy. In a theoretical sense, it would be just as improper to decry the recent 6-month episode of inflation as it would be to praise the previous 8-month downward trend in the CPI—doing either without qualification would grossly oversimplify the economic problems driving those changes.
  • Federal relief spending for the pandemic has left many households with unusually high disposable income, further adding to fears of rising inflation. For instance, per capita disposable personal income increased 14 percent from January through March, far greater than the average first-quarter increase (0.43 percent) during the last decade. Given that this increase is largely due to deficit-financed federal spending, many people (correctly) fear higher inflation due to the classic “too many dollars chasing too few goods” phenomenon as the recovery takes hold.
  • Even though policymakers must remain vigilant, the broader CPI trends from the recent past (thankfully) look very different from those in the 1970s. For example, in the past 10 years, the highest annual (January to December) increase in the CPI was in 2011 at 2.73 percent, and the annual CPI inflation rate proceeded to fall for the next three years, dropping to 0.41 percent in 2014. (The core PCE index, the Fed’s preferred inflation measure, displayed the same trend over this period.) In fact, inflation has been low by historical standards for the past two decades. Between 2000 and 2020, average annual inflation was 1.89 percent using the CPI and 1.59 percent if measured with the PCE. In contrast, the lowest annual increase in the CPI between 1966 and 1980 was 3.01 percent (in 1971), and the highest annual rate of inflation during this period was 12.26 percent (in 1979). The average annual increase between 1970 and 1980 was 7.18 percent.
  • Just as no single figure objectively represents inflation that is “too high,” there is no independent definition of “stable” prices. At least since the 1990s, Fed officials have interpreted this portion of their mandate to require consistently low inflation, where “low” is approximately 2 percent. If CPI inflation had been exactly 2 percent per year since 2000, the CPI would just now—after these rapid increases of the past few months—be getting back to its projected level for 2021. To be fair, the Fed did not officially target inflation until 2012, and if inflation had been exactly 2 percent per year since 2012, the CPI would still be below its projected level for 2021. (See Figure 1.)

Figure 1. 

  • Historically, inflation has most often been caused by excessive increases in the money supply. However, this relationship is not as simple as it sounds. For starters, the relationship between the quantity of money and the price level is not one-for-one. Moreover, the timing of these price level changes has typically been subject to long and variable lags.
  • Although there is a natural (sometimes justified) tendency to associate inflation with “printing” additional money, the historical relationship between annual changes in money and inflation (using the M2 aggregate measure for money and the overall PCE index for inflation) shows that inflation has been low and stable for decades even following large increases in money. In fact, dating to 1960, annual changes in the core PCE display very little correlation with M2 growth. (See Figure 2 and Figure 3.)

Figure 2.


Figure 3.

  • One problem with the simple association of money growth and inflation is that it ignores changes in the velocity of money, a term that indicates how rapidly each dollar in the economy is being spent. If, for example, the velocity of money is decreasing, then individuals in the economy are conducting fewer transactions (and the demand for money—or holding onto money balances—is increasing). Because a rapid decline in velocity offsets the inflationary effects of an increase in the money supply, proper monetary policy requires the Fed to offset changes in velocity with changes in the money supply. The data, in fact, indicate that the Fed appropriately offset a decline in velocity during the pandemic. As Figure 4 shows, velocity decreased in early 2020, and the Fed correspondingly allowed the M2 aggregate to increase.

Figure 4.

  • Even now, in late November, there is more than enough evidence of supply-side problems throughout the economy. For any inflation-targeting central bank, this situation is problematic. Specifically, this type of negative shock leads to higher prices due to fewer goods and services in the economy, leaving the (inflation-targeting) central bank in the unenviable position of trying to lower the rate of inflation by decreasing the amount of money in the economy. The problem, of course, is that shrinking the money supply in this situation would starve the economy even further. Put differently, by pursuing price stability in the face of a negative supply shock, the central bank would provide even less money to purchase even scarcer items, thus making it more difficult for people to buy the goods and services they need.
  • In the face of these types of supply-driven changes in the economy, an inflation-targeting central bank always pushes against the natural market forces that drive price changes. What Americans are now faced with, therefore, is the textbook example of why central banks should not target price stability. The price level should, instead, be allowed to vary to reflect changes in goods’ production cost.
  • The fact that the CPI has been increasing after large increases in federal deficit spending has added to the public’s inflation fears. Even prior to President Joe Biden’s initial $1.9 trillion COVID-19 relief package, the federal government had already increased the national debt by $4.5 trillion in 2020, and the Congressional Budget Office estimated that publicly held federal debt would reach 102 percent of GDP by the end of 2021. In the wake of that spending spree, Congress passed a new $1 trillion infrastructure bill, and has now turned its attention to another multi-trillion dollar spending bill. These types of deficit spending programs will not alleviate shortages. They will not create more livestock, provide more workers, or clear shipping bottlenecks. Instead, they will provide people with more funds to pay suppliers who still face many of the same supply constraints that caused the shortages in the first place. These programs have already put upward pressure on prices, and implementing more of them will put more upward pressure on prices because they will “intensify competition for scarce materials and labor.”

Given this set of facts, I still believe that Federal Reserve officials should not panic over the recent inflation surge. They should, as they have to date, be very cautious about raising their interest rate targets and tightening their policy stance. The Fed should not tighten its policy stance for the sake of hitting an inflation target until the economy has recovered. Fed officials should, on the other hand, shrink the money supply if they see a decrease in the demand for money.

So far, measures that would indicate such a decrease in money demand do not warrant any sort of dramatic action—the velocity of money looks stable, and nominal GDP appears to have recovered to its pre-pandemic trend. (See Figure 5, courtesy of David Beckworth at Mercatus.) Moreover, as seen above in Figure 1, inflation seems to be pretty much back to its pre-COVID-19 trend. So, while the risk for accelerating inflation is now much higher than it was previously, there is no indication that the Fed has lost control of inflation. It is also true that the current inflation surge is consistent with the policy framework it uses to implement its federal mandate. (Whether the Fed should have so much discretion to decide how to fulfill its mandate is a separate question.)

Figure 5.

The Fed should start to normalize monetary policy, but that doesn’t mean what it meant in the 1970s. Instead, normalization refers broadly to backing off and becoming less involved in both fiscal policy and financial markets. The Fed and Congress have breached the traditional boundaries between the monetary and fiscal authorities, thus making it easier for the Fed to engage in strictly fiscal quantitative easing operations. This type of financing is favored by supporters of large-scale infrastructure projects and helicopter money proposals. Arguably, these kinds of programs are always inflationary, but they certainly will result in more upward pressure on prices if supply constraints remain in the economy.

Normalizing also refers to ditching the Fed’s post-2008 operating framework, the regime it implemented during the financial crisis. If the Fed does not revert to its traditional (pre-2008) operating framework on its own, start shrinking its balance sheet, and ending its mortgage-backed securities purchases, Congress should require the Fed to do so over a specific period. Normalizing policy with these actions is far more important for the long-run economic outlook than whether the Fed raises its rate target by 0.25 percent in December 2021 or waits until January 2022.

Of course, everyone wants to know what Fed officials should do with that rate target. (Should they raise it? By how much? Should they wait?) Unfortunately, knowing exactly when to tighten its policy stance is not an exact science, and the same goes for precisely how much to raise its targets. Reasonable people can disagree on this point, but the main economic indicators suggest a 0.25 target rate increase in December or January would be prudent—both NGDP and inflation appear to be back to their pre-pandemic trends and still increasing. (I do not believe that it would make much difference if the Fed hiked its target in December or waited until January, but a hike in December would do more to calm people’s inflation fears than waiting, so the earlier choice might make more sense.)

Going forward, sound monetary policy dictates that the Fed should tolerate a higher price level provided that the rate of inflation does not continue to climb and push NGDP too far above its pre-pandemic trend. Admittedly, accomplishing this goal is not as simple as it sounds. Neither, however, is straight inflation targeting in the absence of a pandemic or even a plain vanilla recession. Nonetheless, both inflation and NGDP seem to be very close to their pre-pandemic trends and rising, so the Fed probably won’t be able to tolerate increasing inflation much longer without harmful consequences. (Speaking of harmful consequences: Another reason for the Fed to fully normalize is that its new inflation control mechanism requires it to pay large banks to sit on reserves, and those payments will become increasingly largeand politically problematic—as interest rates rise.)

Aside from these monetary policy prescriptions, here are several steps that federal officials can take to relieve supply constraints and help alleviate upward price pressures.

  • Continue lifting COVID-19 restrictions and promoting vaccines. COVID-19 created a global pandemic, infected over 35 million Americans, and claimed the lives of over 600,000. Although the data clearly show that vaccines have reduced the risk of serious illness and death from COVID-19 to near-zero, and made infection much less likely, public officials have continued to confuse Americans by providing conflicting messages, often unconnected to any supporting data. Throughout the pandemic, in fact, government officials have stubbornly promoted uniform policies of widespread lockdowns, shunning policies tailored to the age-related risk disparities of COVID-19. They have pushed a distorted view of COVID-19 risk on tens of millions of Americans, stoking a climate of fear instead of rationality. Even now, many public officials seem incapable of distinguishing between the risk of getting infected and the risk of serious illness and death—which is predominantly a problem among the unvaccinated. Not only has this failure needlessly created widespread panic, but it has also slowed down, and sometimes prevented, the provision of more targeted public health interventions needed by those most at risk. Government officials should stop politicizing the pandemic: They should lift COVID-19 restrictions, promote vaccines, and provide targeted public health solutions to those most at risk. (The Biden administration should also drop its constitutionally questionable push to impose a vaccine mandate on businesses.)
  • Forgo additional stimulus spending. Given that prior stimulus bills have left so many households with unusually high disposable income levels, and that business owners are having a difficult time hiring the workers they need, the normal justification for these kinds of spending programs does not currently exist. There is no widespread lack of consumer demand or job opportunities, so additional deficit spending will do little more than lead to upward pressure on prices and higher federal debt. The recognition that persistently high levels of debt and deficit spending can lead to inflation and economic instability is hardly new (see page 10).
  • Remove regulatory barriers that hinder economic opportunity. Numerous government regulations exist that drive up consumer prices, including those for food and energy. Many of these policies disproportionately hurt the poor, even during normal times when people are not struggling to deal with pandemic-related economic problems. Thus, now is the perfect time to start eliminating the countless government-imposed economic roadblocks that put upward pressure on prices. For instance, the federal government regulates a long list of consumer and commercial appliances, including refrigerators, air conditioners, furnaces, televisions, showerheads, ovens, toilets, and light bulbs. These regulations prioritize efficiency over other preferences that customers and businesses might have, such as safety, size, durability, and cost. The renewable fuel standard, passed in 2005 and expanded in 2007, mandates that billions of gallons of ethanol (primarily corn-based ethanol) be blended into gasoline and diesel each year—a requirement that, according to the Government Accountability Office, pushes fuel prices higher for limited, if any, environmental or climate benefit. Moreover, using crops to make fuel can result in additional scarcity (and higher prices) in food markets. Congress should also curb regulatory abuses by the current Administration, which is restricting access to energy resources and increasing the costs of energy through policies such as canceling the Keystone pipeline and placing a moratorium on oil and gas permitting on federal lands. (There are many other examples of ways to lower regulatory burdens and consumer costs, especially in energy markets.)
  • Remove tariffs and trade restrictions. Congress and the Administration should promote freer trade by reducing both tariff and non-tariff barriers. International trade is generally driven by the ability of people in various countries—through comparative advantages—to deliver lower-priced goods to consumers. For instance, one recent study estimates that the prices of goods that tend to be traded fell between 2002 and 2012, whereas the prices of goods which tend not to be imported rose during the period. The pandemic has disrupted trade and contributed to higher prices for many goods, and even Treasury Secretary Janet Yellen recently argued that removing tariffs “would make some difference” toward curbing inflation because “[t]ariffs do tend to raise domestic prices.” Between 2018 and 2020, for instance, Americans paid $7.5 billion in extra steel tariffs. Tariffs on specific items can even raise prices of complementary Research shows, for example, that the price of washing machines rose by nearly 12 percent in response to the 2018 tariffs, and that “the price of dryers—a complementary good not subject to tariffs—increased by an equivalent amount.” (For more on the beneficial effects of removing tariffs and non-tariff trade restrictions, see Cato scholars’ research here, here, here, here, and here.)
  • Replace the Fed’s dual mandate. Congress can greatly improve monetary policy by replacing the Federal Reserve’s current legislative mandate to promote stable prices and maximum employment. Instead, Congress should give the Fed a mandate with the single goal of achieving monetary neutrality by stabilizing overall spending in the economy. A central bank that targets total spending has the best chance of achieving monetary neutrality because it effectively requires it to respond to changes in money velocity. This framework would be superior to inflation targeting—particularly in the face of supply shocks to the economy—because it would allow prices to better reflect goods’ actual scarcities and because it would avoid major information problems faced by inflation-targeting central banks. Similarly, the central bank would no longer directly respond to changes in unemployment, which is a benefit because maximum employment is largely determined by non-monetary factors. Targeting total spending also allows the price level to decline as productivity improves, thus allowing people to enjoy the benefits of a growing economy, with more goods for sale at lower prices. (It is true, a growing economy does not have to result in rising prices.) Given the current episode of inflation, moving to nominal spending targeting could result in a permanently higher price level, but that fact alone is not problematic. Provided that nominal spending growth remains stable over the next few years, in the range of 3 percent to 4 percent, then the recent episode of high inflation will dissipate.

Higher food and gasoline prices have been two of the main drivers of the recent CPI surge, so consumers’ inflation concerns are perfectly understandable. Yet, if policymakers respond inappropriately to these recent price increases, they will likely worsen the economic difficulties that Americans now face, prolonging the recovery. Most importantly, it would be improper for the Federal Reserve to immediately tighten its policy stance for the sake of hitting an inflation target, and it would be a mistake for Congress to enact new deficit-financed spending proposals.

Policies that fail to alleviate specific supply disruptions run the risk of making it even more difficult for people to get the goods and services that they need. If Congress is truly concerned about high prices, especially those for food and energy, now is the perfect time to start eliminating the countless government-imposed economic roadblocks that already create upward price pressures in those sectors. It is also long past the time to normalize monetary policy (getting rid of the Fed’s 2008 crisis-era operating framework, reducing its distortionary actions in financial markets, and reclarifying the line between monetary and fiscal policy) and to replace the Fed’s dual mandate with a single mandate for monetary neutrality (one that relies on targeting total nominal spending).

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