Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared at Project Syndicate.
Are the US and other advanced countries experiencing stagflation? Stagflation is the unfortunate combination of high inflation with low growth in output and employment that characterized the mid-1970s. Are we back in that decade?
No. At least not the US. What it is experiencing now is simply (moderate) inflation, without the stagnation part. More like the 1960s than the 1970s.
It is true that the US headline CPI inflation rate reached 6.2 % over the 12 months to October, the highest since 1991. Few are still forecasting an early return to 2 % , the Fed’s long-run target. Inflation is also the highest in 10 years in the UK (4.2 %) and the EU (4.4 %), though it remains low in Japan. 12-month inflation is 4.1 % in the eurozone, the highest since a peak in July 2008. (All these regions have lower – but still elevated — inflation rates if one uses the core measure, which takes out fast-rising food and energy prices. US core inflation is 4.6%.)
But the US economic recovery since the pandemic recession of 2020 has been strong, judged by GDP and labor market indicators. This is not the stagflation of the 1970s.
* * *
1. Why has inflation risen in 2021?
Inflation is the natural result when demand increases faster than supply.
Rising American demand for goods (which had been pent-up when Covid kept people home), is confronting a constrained supply of goods, resulting in price inflation. The supply constraints include port bottlenecks, chip shortages, and other supply chain disruptions, particularly for in-demand durable goods. Meanwhile, rising demand for labor is confronting a supply of labor constrained by the lingering effects of the pandemic (particularly for services), which has resulted in wage inflation, especially in the lower parts of the wage distribution.
GDP in the US has already surpassed pre-pandemic levels. In contrast, GDP in many other countries, including the Brexit-impacted United Kingdom, has not caught up with where it was before.
It is true that US real GDP has yet to attain its pre-pandemic trend. The evidence suggests, however, that the reason for this remaining shortfall in output is not inadequate demand, but rather capacity constraints. They are probably temporary.
US unemployment is down a lot. From 14.8 % in April 2020, it declined to 4.6% last month, October 2021, which would have been considered close to full employment during most of the last half-century. By contrast, unemployment reached 9.0% in the stagflationary time of May 1975 (on its way to 10.8 % in November 1982). Moreover, other current indicators point to a tighter labor market than the unemployment rate does: the ratio of job vacancies to unemployed workers is the highest on record, as is the quit rate, reflecting confidence that workers can find new jobs. Wage growth is also up. (Workers at the lower end, in particular, are pulling ahead of price inflation.)
Only Labor Force Participation remains substantially depressed. Some of the decline is due to retirements. Much is due to Covid, still a big factor in the economy.
What is the evidence that the problem is not demand, which monetary and fiscal expansion could do something about, but rather inadequate supply, which they cannot? For one thing, nominal GDP has attained its pre-pandemic long-term trend, suggesting that supply is now the constraint on real growth and that demand is about right. For another thing, direct measures of domestic demand, like real personal spending or retail sales, have also attained their long-term pre-pandemic trends.
When demand exceeds supply, the results include a trade deficit and inflation. That is basic macroeconomics. We are currently witnessing both.
Though it may not seem like it, these are, in a sense, good problems to have (taking the pandemic as given). It is clearly better to have demand and supply both recovering, albeit with demand recovering more quickly, than to have neither recovering, with economic activity and employment depressed as in 2020, when the pandemic induced a sharp recession, due to declines in both supply and demand. The US is way ahead of where we thought we would be a year ago, and ahead of other countries.
Monetary policy can do nothing about the capacity constraints. Nevertheless, it is not too much to hope that they will melt away over the next year, as ports unclog, supply chains re-form, choosier workers successfully match with jobs that they actually want, and supply responds to high prices in those particular sectors where excess demand is acute. As a result, economic activity may catch up with its pre-pandemic trend before long.
* * *
2. Policy-makers won’t repeat mistakes of the 1970s
Rather than resembling the 1970s, today is perhaps more like the late 1960s, which was another time of rapid growth and tight labor markets. Consumer inflation reached a moderate 5 ½ % in 1969. But many worry that today’s moderate inflation will eventually get built into expectations, set off a wage-price spiral, and soon turn into the high inflation of the 1970s. This is not impossible. We don’t want to dismiss the lessons of the past by remaining complacent about inflation. (By analogy, supporters of the US wars in Afghanistan and Iraq, condemned to repeat the mistakes of the past, assured us that the Vietnam War was not a relevant precedent.)
But it is quite unlikely that our policy-makers will in fact repeat the mistakes made in the late 1960s and early 1970s. These mis-steps began with Vietnam-War-era increases in government spending, without tax revenues to pay for it.
The errors were multiplied in the early 1970s. In 1971, Fed Chairman Arthur Burns and President Richard Nixon responded to rising inflation with a combination of rapid monetary stimulus (to secure the president’s re-election) and doomed wage-price controls (to artificially suppress inflation in the short run). An overheating economy blew the lid off the boiling pot a few years later, and inflation shot above 12 per cent.
It is true that the Fed was overly optimistic in its forecasts for inflation this year. By that, I mean that the Fed (like many others) was expecting the increase in inflation to be smaller and more transitory. (It takes an effort to remember that, until recently, “optimistic about inflation” meant expecting inflation to be higher, not lower.) Larry Summers and Olivier Blanchard got it right back in February of this year, correctly predicting that rapid growth would lead to inflation.
Even though the Fed turns out to have been off-target in its inflation forecasts, it has arguably not been far off-target in its actions. True, the central bank did not expect to start tapering as early as November 2021. But it responded appropriately to the incoming data — on inflation, as well as on the strength of the economy — by adjusting the timing of its plans.
The Fed’s mistake in forecasting its own policies does not appear to have done any harm. One could imagine that securities markets might have crashed when the Federal Open Market Committee announced tapering on November 3. But markets hardly reacted at all, indicating that the Fed had successfully communicated its re-thinking, in contrast to 1994 and 2013, when the markets failed to anticipate the start of tightening cycles.
If the Fed – under newly re-appointed Chair Jay Powell –starts raising short term interest rates in the middle of 2022, or even slightly sooner, it won’t catch markets by surprise. (Not that the Fed’s job is to keep stock market investors happy.)
* * *
3. What can Biden do about inflation
What can the White House do in response to the highly unpopular recent rise in inflation? Its tools are limited. The Biden Administration has already intervened a bit to help get ports and other supply chain logistics unclogged.
Most sensitive politically is the price of gasoline, which is back up near its levels of 2011-2014. There is not much the President can do about the world price of oil. But at least he will not do what Trump did on April 2, 2020 (in order to help out American oil producers), which was to tell Saudi Arabia that OPEC must cut oil output or else the US would withdraw troops from the Arabian peninsula.
Further vaccination would increase the supply of labor, through several possible channels. One channel would be to keep children in school, allowing more parents to go back to work. Another channel is to alleviate fears of infection in the workplace. We hear that vaccination mandates could result in some employees quitting. But the vaccine skeptics are out-numbered by those workers who understand the benefits and should be attracted by the idea of rules to make their work-places near Covid-free. It is hard to know, however, what more Biden could do to convince the unconvinced.
A good, but neglected, way to moderate inflation would be to let imports come into the country more easily. They are a safety valve for an overheated economy. Trump put up a lot of tariffs – including on aluminum and steel, and everything Americans import from China. Tariffs raise prices to consumers, sometimes directly, as with washing machines, and sometimes indirectly, as with steel and aluminum, which are important inputs into autos and countless other goods. In some cases, the legacy of Trump protectionism has contributed directly to current disruption of supply chain logistics, such as the high tariffs on imports of chassis, which are the wheeled frames that carry shipping containers.
“Buy American” is attractive as a political slogan. But it is a recipe for worsening inflation.
Biden should be able to get China and other countries to reciprocally lower some barriers against the US, in return for removing US tariffs. But with or without foreign reciprocation, trade liberalization could bring some prices down quickly. As Menzie Chinn points out, reducing tariffs would have a bigger anti-inflation today than in the 1970s, because trade is a much larger share of the economy now than then.
Facilitating immigration (preferably orderly and legal) could alleviate shortages of workers in some sectors.
Biden’s “Build Back Better” social spending bill, often identified with costs around $2 trillion, passed the House of Representative November 19 and awaits a Senate vote. Republicans argue that such spending will add to inflation. The cost numbers are misleadingly large. (1) They are spread over 10 years; annual costs are much smaller. (2) Some rising spending would be expected in a growing economy anyway. (3) The White House proposal is to pay for the social spending bill fully, by funding IRS enforcement and raising taxes on corporations and on citizens earning more than $400,000.
Some argue that the new spending would, on net, work to raise inflation, e.g., because a dollar of spending raises demand by more than a dollar of tax revenue reduces it. Others argue that the net effect on inflation will be beneficial (particularly in the longer run), because many of the programs, such as universal quality pre-school, operate to increase supply. Both arguments are reasonable. Regardless, the infrastructure spending and social spending should be judged on their own merits. Inflation is explained, not by this legislation, but by rapid recovery from the Covid recession.
This post written by Jeffrey Frankel.