In January 2022, the Bureau of Labor Statistics (BLS) announced that inflation, measured as the percentage change in the consumer price index (CPI) from December 2020 to December 2021, was 7 percent. That was the highest rate since June 1982, which was near the end of the Great Inflation that lasted from 1968 to 1982. The following figure shows the inflation rate since the beginning of 1948.
What explains the surge in inflation? Most economists believe that it is the result of the interaction of increases in aggregate demand resulting from very expansionary monetary and fiscal policy and disruptions to supply in some industries as a result of the Covid-19 pandemic. (We discuss movements in aggregate demand and aggregate supply during the pandemic in the updated editions of Economics, Chapter 23, Section 23.3 and Macroeconomics, Chapter 13, Section, 13.3.)
But President Joe Biden has suggested that mergers and acquisitions in some industries—he singled out meatpacking—have reduced competition and contributed to recent price increases. Massachusetts Senator Elizabeth Warren has made a broader claim about reduced competition being responsible for the surge in inflation: “Market concentration has allowed giant corporations to hide behind claims of increased costs to fatten their profit margins. [Corporations] are raising prices because they can.” And “Corporations are exploiting the pandemic to gouge consumers with higher prices on everyday essentials, from milk to gasoline.”
Do many economists agree that reduced competition explains inflation? The Booth School of Business at the University of Chicago periodically surveys a panel of more than 40 well-known academic economists for their opinions on significant policy issues. Recently, the panel was asked whether they agreed with these statements:
A significant factor behind today’s higher US inflation is dominant corporations in uncompetitive markets taking advantage of their market power to raise prices in order to increase their profit margins.
Antitrust interventions could successfully reduce US inflation over the next 12 months.
Price controls as deployed in the 1970s could successfully reduce US inflation over the next 12 months.
Large majorities of the panel disagreed with statements 1. and 2.—that is, they don’t believe that a lack of competition explains the surge in inflation or that antitrust actions by the federal government would be likely to reduce inflation in the coming year. A smaller majority disagreed with statement 3., although even some of those who agreed that price controls would reduce inflation stated that they believed price controls were an undesirable policy. For instance, while he agreed with statement 3., Oliver Hart of Harvard noted that: “They could reduce inflation but the consequence would be shortages and rationing.”
One way to characterize the panel’s responses is that they agreed that the recent inflation was primarily a macroeconomic issue—involving movements in aggregate demand and aggregate supply—rather than a microeconomic issue—involving the extent of concentration in individual industries.
Sources for Biden and Warren quotes: Greg Ip, “Is Inflation a Microeconomic Problem? That’s What Biden’s Competition Push Is Betting,” Wall Street Journal, January 12, 2022; and Patrick Thomas and Catherine Lucey, “Biden Promotes Plan Aimed at Tackling Meat Prices,” Wall Street Journal, January 3, 2022; and https://twitter.com/SenWarren/status/1464353269610954759?s=20
Lawrence Summers, professor of economics at Harvard University and secretary of the Treasury under President Bill Clinton, has been outspoken in arguing that monetary and fiscal have been too expansionary. In February 2021, just before Congress passed the American Rescure Plan, which increased federal government spending by $1.9 trillion, Summers cautioned that “there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability.”
In a brief CNN interview found at this LINK, Summers indicates that he remains concerned that inflation may persist at high levels for a longer period than many other economists, including policymakers at the Federal Reserve, believe.
Source for quote: Lawrence H. Summers, “The Biden Stimulus Is Admirably Ambitious. But It Brings Some Big Risks, Too,” Washington Post, February 4, 2021.
According to the Federal Reserve Act, the Fed must conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Neither “maximum employment” nor “stable prices” are defined in the act.
The Fed has interpreted “stable prices” to mean a low rate of inflation. Since 2012, the Fed has had an explicit inflation target of 2 percent. When the Fed announced its new monetary policy strategy in August 2020, it modified its inflation target by stating that it would attempt to achieve an average inflation rate of 2 percent over time. As Fed Chair Jerome Powell stated: “Our approach can be described as a flexible form of average inflation targeting.” (Note that although the consumer price index (CPI) is the focus of many media stories on inflation, the Fed’s preferred measure of inflation is changes in the core personal consumption expenditures (PCE) price index. The PCE is a broader measure of the price level than is the CPI because it includes the prices of all the goods and services included in consumption category of GDP. “Core” means that the index excludes food and energy prices. For a further discussion see, Economics, Chapter 25, Section 15.5 and Macroeconomics, Chapter 15, Section 15.5.)
There is more ambiguity about how to determine whether the economy is at maximum employment. For many years, a majority of members of the Federal Open Market Committee (FOMC) focused on the natural rate of unemployment (also called the non-accelerating rate of unemployment (NAIRU)) as the best gauge of when the U.S. economy had attained maximum employment. The lesson many economists and policymakers had taken from the experience of the Great Inflation that lasted from the late 1960s to the early 1980s was if the unemployment rate was persistently below the natural rate of unemployment, inflation would begin to accelerate. Because monetary policy affects the economy with a lag, many policymakers believed it was important for the Fed to react before inflation begins to significantly increase and a higher inflation rate becomes embedded in the economy.
At least until the end of 2018, speeches and other statements by some members of the FOMC indicated that they continued to believe that the Fed should pay close attention to the relationship between the natural rate of unemployment and the actual rate of unemployment. But by that time some members of the FOMC had concluded that their decision to begin raising the target for the federal funds rate in December 2015 and continuing raising it through December 2018 may have been a mistake because their forecasts of the natural rate of unemployment may have been too high. For instance, Atlanta Fed President Raphael Bostic noted in a speech that: “If estimates of the NAIRU are actually too conservative, as many would argue they have been … unemployment could have averaged one to two percentage points lower” than it actually did.
Accordingly, when the Fed announced its new monetary policy strategy in August 2020, it indicated that it would consider a wider range of data—such as the employment-population ratio—when determining whether the labor market had reached maximum employment. At the time, Fed Chair Powell noted that: “the maximum level of employment is not directly measurable and [it] changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”
As the economy recovered from the effects of the Covid-19 pandemic, the Fed faced particular difficulty in assessing the state of the labor market. Some labor market indicators appeared to show that the economy was close to maximum employment while other indicators showed that the labor market recovery was not complete. For instance, in December 2021, the unemployment rate was 3.9 percent, slightly below the average of the FOMC members estimates of the natural rate of unemployment, which was 4.0 percent. Similarly, as the first figure below shows, job vacancy rates were very high at the end of 2021. (The BLS calculates job vacancy rates, also called job opening rates, by dividing the number of unfilled job openings by the sum of total employment plus job openings.) As the second figure below shows, job quit rates were also unusually high, indicating that workers saw the job market as being tight enough that if they quit their current job they could find easily another job. (The BLS calculates job quit rates by dividing the number of people quitting jobs by total employment.) By those measures, the labor market seemed close to maximum employment.
But as the first figure below shows, total employment in December 2021 was still 3.5 million below its level of early 2020, just before the U.S. economy began to experience the effects of the pandemic. Some of the decline in employment can be accounted for by older workers retiring, but as the second figure below indicates, employment of prime-age workers (those between the ages of 25 and 54), had not recovered to pre-pandemic levels.
How to reconcile these conflicting labor market indicators? In January 2022, Fed Chair Powell testified before the Senate Banking Committee as the Senate considered his nomination for a second four-year term as chair. In discussing the state of the economy he offered the opinion that: “We’re very rapidly approaching or at maximum employment.” He noted that inflation as measured by changes in the CPI had been running above 5 percent since June 2021: “If these high levels of inflation get entrenched in our economy, and in people’s thinking, then inevitably that will lead to much tighter monetary policy from us, and it could lead to a recession.” In that sense, “high inflation is a severe threat to the achievement of maximum employment.”
At the time of Powell’s testimony, the FOMC had already announced that it was moving to a less expansionary monetary policy by reducing its purchases of Treasury bonds and mortgage-backed securities and by increasing its target for the federal funds rate in the near future. He argued that these actions would help the Fed achieve its dual mandate by reducing the inflation rate, thereby heading off the need for larger increases in the federal funds rate that might trigger a recession. Avoiding a recession would help achieve the goal of maximum employment.
Powell’s remarks did not make explicit which labor market indicators the Fed would focus on in determining whether the goal of maximum employment had been obtained. It did make clear that the Fed’s new policy of average inflation targeting did not mean that the Fed would accept inflation rates as high as those of the second half of 2021 without raising its target for the federal funds rate. In that sense, the Fed’s monetary policy of 2022 seemed consistent with its decades-long commitment to heading off increases in inflation before they lead to a significant increase in the inflation rate expected by households, businesses, and investors.
Note: For a discussion of the background to Fed policy, see Economics, Chapter 25, Section 25.5 and Chapter 27, Section 17.4, and Macroeconomics, Chapter 15, Section 15.5 and Chapter 17, Section 17.4.
Sources: Jeanna Smialek, “Jerome Powell Says the Fed is Prepared to Raise Rates to Tame Inflation,” New York Times, January 11, 2022; Nick Timiraos, “Fed’s Powell Says Economy No Longer Needs Aggressive Stimulus,” Wall Street Journal, January 11, 2022; and Federal Open Market Committee, “Meeting Calendars, Statements, and Minutes,” federalreserve.gov, January 5, 2022.
Jerome Powell (photo from the Wall Street Journal)
Most economists believe that monetary policy actions, such as changes in the Fed’s pace of buying bonds or in its target for the federal funds rate, affect real GDP and employment only with a lag of several months or longer. But monetary policy actions can have a more immediate effect on the prices of financial assets like stocks and bonds.
Investors in financial markets are forward looking because the prices of financial assets are determined by investors’ expectations of the future. (We discuss this point in Economics and Microeconomics, Chapter 8, Section 8.2, Macroeconomics, Chapter 6, Section 6.2, and Money, Banking and the Financial System, Chapter 6.) For instance, stock prices depend on the future profitability of firms, so if investors come to believe that future economic growth is likely to be slower, thereby reducing firms’ profits, the investors will sell stocks causing stock prices to decline.
Similarly, holders of existing bonds will suffer losses if the interest rates on newly issued bonds are higher than the interest rates on existing bonds. Therefore, if investors come to believe that future interest rates are likely to be higher than they had previously expected them to be, they will sell bonds, thereby causing their prices to decline and the interest rates on them to rise. (Recall that the prices of bonds and the interest rates (or yields) on them move in opposite directions: If the price of a bond falls, the interest rate on the bond will increase; if the price of a bond rises, the interest rate on the bond will decrease. To review this concept, see the Appendix to Economics and Microeconomics Chapter 8, the Appendix to Macroeconomics Chapter 6, and Money, Banking, and the Financial System, Chapter 3.)
Because monetary policy actions can affect future interest rates and future levels of real GDP, investors are alert for any new information that would throw light on the Fed’s intentions. When new information appears, the result can be a rapid change in the prices of financial assets. We saw this outcome on January 5, 2022, when the Fed released the minutes of the Federal Open Market Committee meeting held on December 14 and 15, 2021. At the conclusion of the meeting, the FOMC announced that it would be reducing its purchases of long-term Treasury bonds and mortgage-backed securities. These purchases are intended to aid the expansion of real GDP and employment by keeping long-term interest rates from rising. The FOMC also announced that it intended to increase its target for the federal funds rate when “labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.”
When the minutes of this FOMC meeting were released at 2 pm on January 5, 2022, many investors realized that the Fed might increase its target for the federal funds rate in March 2022—earlier than most had expected. In this sense, the release of the FOMC minutes represented new information about future Fed policy and the markets quickly reacted. Selling of stocks caused the S&P 500 to decline by nearly 100 points (or about 2 percent) and the Nasdaq to decline by more than 500 points (or more than 3 percent). Similarly, the price of Treasury securities fell and, therefore, their interest rates rose.
Investors had concluded from the FOMC minutes that economic growth was likely to be slower during 2022 and interest rates were likely to be higher than they had previously expected. This change in investors’ expectations was quickly reflected in falling prices of stocks and bonds.
Sources: An Associated Press article on the reaction to the release of the FOMC minutes can be found HERE; the FOMC’s statement following its December 2021 meeting can be found HERE; and the minutes of the FOMC meeting can be found HERE.
When Congress established the Federal Reserve System in 1913, it intended to make the Fed independent of the rest of the federal government. (We discuss this point in the opener to Macroeconomics, Chapter 15 and to Economics, Chapter 25. We discuss the structure of the Federal Reserve System in Macroeconomics, Chapter 14, Section 14.4 and in Economics, Chapter 24, Section 24.4.) The ultimate responsibility for operating the Fed lies with the Board of Governors in Washington, DC. Members of the Board of Governors are nominated by the president and confirmed by the Senate to 14-year nonrenewable terms. Congress intentionally made the terms of Board members longer than the eight years that a president serves (if the president is reelected to a second term).
The president is still able to influence the Board of Governors in two ways:
The terms of members of the Board of Governors are staggered so that one term expires on January 31 of each even-number year. Although this approach means that it’s unlikely that a president will be able to appoint all seven members during the president’s time in office, in practice, many members do not serve their full 14-year terms. So, a president who serves two terms will typically have an opportunity to appoint more than four members of the Board.
The president nominates one member of the Board to serve a renewable four-year term as chair, subject to confirmation by the Senate.
The terms of Fed chairs end in the year after the year a president begins either the president’s first or second term. As a result, presidents are often faced with what is at times a difficult decision as to whether to reappoint a Fed chair who was first appointed by a president of the other party.
For example, after taking office in January 2009, President Barack Obama, a Democrat, faced the decision of whether to nominate Fed Chair Ben Bernanke to a second term to begin in 2010. Bernanke had originally been appointed by President George W. Bush, a Republican. Partly because the economy was still suffering the aftereffects of the financial crisis and the Great Recession, President Obama decided that it would potentially be disruptive to financial markets to replace Bernanke, so he nominated him for a second term.
After taking office in January 2017, President Donald Trump, a Republican, had to decide whether to nominate Fed Chair Janet Yellen, who had been appointed by Obama, to another term that would begin in 2018. He decided not to reappoint Yellen and instead nominated Jerome Powell, who was already serving on the Board of Governors. Although a Republican, Powell had been appointed to the Board in 2014 by Obama.
President Biden’s reasons for nominating Powell to a second term to begin in 2022 were similar to Obama’s reasons for nominating Bernanke to a second term: The U.S. economy was still recovering from the effects of the Covid-19 pandemic, including the strains the pandemic had inflicted on the financial system. He believed that replacing Powell with another nominee would have been potentially disruptive to the financial system.
There had been speculation that Biden would choose Lael Brainard, who has served on the Board of Governors since 2014 following her appointment by Obama, to succeed Powell as Fed chair. Instead, Biden appointed Brainard as vice chair of the Board. In announcing the appointments, Biden stated: “America needs steady, independent, and effective leadership at the Federal Reserve. That’s why I will nominate Jerome Powell for a second term as Chair of the Board of Governors of the Federal Reserve System and Dr. Lael Brainard to serve as Vice Chair of the Board of Governors.”
Sources: Nick Timiraos and Andrew Restuccia, “Biden Will Tap Jerome Powell for New Term as Fed Chairman,” wsj.com, November 22, 2021; and Jeff Cox and Thomas Franck, “Biden Picks Jerome Powell to Lead the Fed for a Second Term as the U.S. Battles Covid and Inflation,” cnbc.com, November 22, 2021.
A recent publication by economists Regis Barnichon, Luiz E. Oliveira, and Adam H. Shapiro at the Federal Reserve Bank of San Francisco asks that provocative question. “The ‘60s” is a reference to the events that led to the U.S. economy experiencing more than 10 years of high inflation rates. Below is a graph similar to Chapter 15, Figure 15.1 in Macroeconomics (Economics, Chapter 25, Figure 25.1) that shows the inflation rate in the United States as measured by the percentage change in the Consumer Price Index (CPI) for each year since 1952. Economists call the years from 1968 though 1982 the “Great Inflation” because inflation was greater during that period than during any other period in the history of the United States.
As we discuss in Macroeconomics, Chapter 17, Section 17.2 (Economics, Chapter 27, Section 27.2), many economists believe that the Great Inflation began as a result of the Federal Reserve attempting to keep the unemployment rate below the natural rate of unemployment for a period of several years. As predicted by the Phillips Curve, the inflation rate increased and, as Milton Friedman and Edmund Phelps had argued would likely happen, the expected inflation rate eventually increased. The inflation was made worse during the 1970s by two supply shocks resulting from sharp increases in oil prices.
Is the United States on the edge of repeating the experience of the Great Inflation? Earlier this year, Olivier Blanchard of the Peterson Institute for International Economics wrote a paper arguing that the U.S. economy was at significant risk of experiencing a significant acceleration in inflation. His paper included a figure similar to the one below showing the combinations of inflation and unemployment during each year of the 1960s. The figure shows a substantial acceleration in inflation over the course of the decade.
Blanchard notes that:
“The history of the Phillips curve is one of shifts, largely due to the adjustment of expectations of inflation to actual inflation. True, expectations have [currently] been extremely sticky for a long time, apparently not reacting to movements in actual inflation. But, with such overheating, expectations might well deanchor. If they do, the increase in inflation could be much stronger.”
….
“If inflation were to take off, there would be two scenarios: one in which the Fed would let inflation increase, perhaps substantially, and another—more likely—in which the Fed would tighten monetary policy, perhaps again substantially. Neither of these two scenarios is ideal. In the first, inflation expectations would likely become deanchored, cancelling one of the major accomplishments of monetary policy in the last 20 years and making monetary policy more difficult to use in the future. In the second, the increase in interest rates might have to be very large, leading to problems in financial markets.”
The authors of the San Francisco Fed publication are more optimistic. They begin their discussion by observing that because of the pandemic, the state of the labor market is more difficult to assess than in most years. They note that the unemployment rate of 4.8 percent in September 2021 was only slightly below the average unemployment rate over the past 30 years and well above the low unemployment rates of 2019 and early 2021. So, on the basis of the unemployment rate, policymakers at the Fed and in Congress might conclude that the inflation the U.S. economy is experiencing is not the result of overly tight labor markets such as those of the late 1960s. But the job openings rate(sometimes called the vacancy rate) is telling a different story. Job openings are positions that are both available to be filled within the next 30 days and for which firms are actively recruiting applicants from outside the firm. (According to the BLS: “The job openings rate is computed by dividing the number of job openings by the sum of employment and job openings and multiplying that quotient by 100.”)
The authors of the San Francisco Fed study note that “the vacancy rate is well above its 30-year average … and has surpassed its historic highs from the late 1960s … indicating that employers are having a difficult time filling positions. Confirming this high vacancy rate, the fraction of small businesses reporting that job openings are hard to fill is at historic highs ….” The figures below show the vacancy rate and the unemployment rate since January 2016.
The authors combine the unemployment rate and the vacancy rate into a statistic—the vacancy-to-unemployment ratio—that they demonstrate has historically done a better job of explaining movements in inflation than has the unemployment rate. They expect that expansionary fiscal policy will result in an increase in vacancy-to-unemployment ratio and, therefore, an increase in the inflation rate. But they share the view of Blanchard and many other economists that a key issue is “the stability of longer-run inflation expectations.”
We know that in the 1960s, several years of rising inflation made long-run inflation expectations unstable—in terms of the discussion in Chapter 17, the short-run Phillips curve shifted up. We don’t yet know what will happen to inflation expectations in late 2021 and in 2022, so we can’t yet tell how persistent current rates of inflation will be.
Sources: Regis Barnichon, Luiz E. Oliveira, and Adam H. Shapiro, “Is the American Rescue Plan Taking Us Back to the ’60s?,” FRBSF Economic Letter, No. 2021-27, October 18, 2021; Olivier Blanchard, “In Defense of Concerns over the $1.9 Trillion relief Plan,” piie.com, February 18, 2021; and Federal Reserve Bank of St. Louis.
It’s customary for textbook authors to note that “much has happened in the economy” since the last edition of their book appeared. To say that much has happened since we prepared our last edition in 2019 would be a major understatement. Never in the lifetimes of today’s students and instructors have events like those of 2020 and 2021 occurred. The U.S. and world economies had experienced nothing like the Covid-19 pandemic since the influenza pandemic of 1918. In the spring of 2020, the U.S. economy suffered an unprecedented decline in the supply of goods and services as a majority of businesses in the country shut down to reduce spread of the virus. Many businesses remained closed or operated at greatly reduced capacity well into 2021. Most schools, including most colleges, switched to remote learning, which disrupted the lives of many students and their parents.
During the worst of the pandemic, total spending in the economy declined as the unemployment rate soared to levels not seen since the Great Depression of the 1930s. Reduced spending and closed businesses resulted in by far the largest decline in total production in such a short period in the history of the U.S. economy. Congress, the Trump and Biden administrations, and the Federal Reserve responded with fiscal and monetary policies that were also unprecedented.
Our updated Eighth Edition covers all of these developments as well as the policy debates they initiated. As with previous editions, we rely on extensive digital resources, including: author-created application videos and audio recordings of the chapter openers and Apply the Concept features; figure animation videos; interactive real-time data graphs animations; and Solved Problem whiteboard videos.
Glenn and Tony discuss the updated edition in this video:
Sample chapters will be available by October 15.
The full Macroeconomics text will available in early to mid December.
The full Microeconomics text will be available in mid to late December.
If you would like to view the sample chapters or are considering adopting the updated Eighth Edition for the spring semester, please contact your local Pearson representative. You can use this LINK to find and contact your representative.
Authors Glenn Hubbard and Tony O’Brien discuss the recent jobs report falling short of expectations. They also discuss the comments of Fed Chairman Powell’s comments at the Federal Reserve’s recent Jackson Hole conference. They also get to some of the recommendations of a Brookings Task Force, co-chaired by Glenn Hubbard, on ways to address financial stability. Use the links below to see more information about these timely topics: Powell’s Jackson Hole speech:
Join authors Glenn Hubbard and Tony O’Brien as they return for a new academic year! The issues have evolved but the importance of these issues has not waned. We discuss the impact of closures related to the delta variant has on the economy. The discussion extends to the active fiscal and monetary policy that has reintroduced inflation as a topic facing our economy. Many students have little or no experience with inflation so it is a learning opportunity. Check back regularly where Glenn & Tony will continue to wrestle with these important economic concepts and relate them to the classroom!
The U.S. inflation rate has accelerated. As the following figure shows, in mid-2021, inflation, measured as the percentage change in the CPI from the same month in the previous year (the blue line), rose above 5 percent for the first time since the summer of 2008.
As we discuss in an Apply the Concept in Chapter 25, Section 25.5 (Chapter 15, Section 15.5 of Macroeconomics), the Fed prefers to measure inflation using the personal consumption expenditures (PCE) price index. The PCE price index is a measure of the price level similar to the GDP deflator, except it includes only the prices of goods and services from the consumption category of GDP. Because the PCE price index includes more goods and services than the CPI, it is a broader measure of inflation. As the red line in the figure shows, inflation as measured by the PCE price index is generally lower than inflation measured by the CPI. The difference is particularly large during periods in which CPI inflation is especially high, as it was during 2008, 2011, and 2021.
Prices of food and energy are particularly volatile, so the measure of inflation the Fed focuses on most closely is the PCE price index, excluding food and energy prices (the green line in figure). The figure shows that this measure of inflation is more stable than either of the other two measures. For instance, during June 2021, measured by the CPI, inflation was 5.3 percent, but was 3.5 percent when measured by the PCE, excluding food and energy.
In the summer of 2021, even inflation measured by the PCE, excluding food and energy, is running well above the Fed’s long-run target rate of 2 percent. Why is inflation increasing? Most economists and policymakers believe that two sets of factors are responsible:
Increases in aggregate demand. Consumption spending (see the first figure below) has increased as the economy has reopened and people have returned to eating in restaurants, going to the movies, working out in gyms, and spending at other businesses that were closed or operating at reduced capacity. Households have been able to sharply increase their spending because household saving (see the second figure below) soared during the pandemic in response to payments from the federal government, including supplemental unemployment insurance payments and checks sent directly to most households. The increase in federal government expenditures that helped fuel the increase in aggregate demand is shown in the third figure below.
Fed policy has also been strongly expansionary, with the target for the federal funds kept near zero and the Fed continuing its substantial purchases of Treasury notes and mortgage-backed securities. The continuing expansion of the Fed’s balance sheet through the summer of 2021 is shown in the last of the figures below. The Fed’s asset purchases have help keep interest rates low and provided banks with ample funds to loan to households and firms.
2. Reductions in aggregate supply. The pandemic disrupted global supply chains, reducing the goods available to consumers. In the summer of 2021, not all of these supply chain issues had been resolved. In particular, a shortage of computer chips had reduced output of motor vehicles. New cars, trucks, SUVs, and minivans were often selling above their sticker prices. High prices for new vehicles led many consumers to increase their demand for used vehicles, driving up their prices. Between July 2020 and July 2021, prices of new vehicles rose 6.4 percent and prices for used vehicles rose an extraordinary 41.7 percent.
Supply issues also exist in some service industries, such as restaurants and hotels, that have had difficulty hiring enough workers to fully reopen.
Economists and policymakers differ as to whether high inflation rates are transitory or whether the U.S. economy might be entering a prolonged period of higher inflation. Most Federal Reserve policymakers argue that the higher inflation rates in mid-2021 are transitory. For instance, in a statement following its July 28, 2021 meeting, the Federal Open Market Committee noted that: “Inflation has risen, largely reflecting transitory factors.” Although the statement also noted that inflation is “on track to moderately exceed 2 percent for some time.”
In a speech at the end of July, Fed Governor Lael Brainard expanded on the Fed’s reasoning:
“Recent high inflation readings reflect supply–demand mismatches in a handful of sectors that are likely to prove transitory…. I am attentive to the risk that inflation pressures could broaden or prove persistent, perhaps as a result of wage pressures, persistent increases in rent, or businesses passing on a larger fraction of cost increases rather than reducing markups, as in recent recoveries. I am particularly attentive to any signs that currently high inflation readings are pushing longer-term inflation expectations above our 2 percent objective.”
“Currently, I do not see such signs. Most measures of survey- and market-based expectations suggest that the current high inflation pressures are transitory, and underlying trend inflation remains near its pre-COVID trend…. Many of the forces currently leading to outsized gains in prices are likely to dissipate by this time next year. Current tailwinds from fiscal support and pent-up consumption are likely to shift to headwinds, and some of the outsized price increases associated with acute supply bottlenecks may ease or partially reverse as those bottlenecks are resolved.”
Brainard’s remarks highlight a point that we make in Chapter 27, Section 27.1 (Chapter 17, Section 17.1 of Macroeconomics): The expectations of households and firms of future inflation play an important part in determining current inflation. Inflation can rise above and fall below the expected inflation rate in response to changes in the labor market—which affect the wages firms pay and, therefore, the firms’ costs—as well as in response to fluctuations in aggregate supply resulting from positive or negative supply shocks—such as the pandemic’s negative effects on aggregate supply. Fed Chair Jerome Powell has argued that with households and firms’ expectations still well-anchored at around 2 percent, inflation was unlikely to remain above that level in the long run.
Some economists are less convinced that households and firms will continue to expect 2 percent inflation if they experience higher inflation rates through the end of 2021. The Wall Street Journal’s editorial board summed up this view: “One risk for the Fed is that more months of these price increases will become what consumers and businesses come to expect. To use the Fed jargon, prices would no longer be ‘well-anchored.’ That may be happening.”
As we discuss in Chapter 27, Sections 27.2 and 27.3 (Macroeconomics, Chapter 17, Sections 17.2 and 17.3), during the late 1960s and early 1970s, higher rates of inflation eventually increased households and firms’ expectations of the inflation rate, leading to an acceleration of inflation that was difficult for the Fed to reverse.
Earlier this year, Olivier Blanchard of the Peterson Institute for International Economics, formerly a professor of economics at MIT and director of research at the International Monetary Fund, raised the possibility that overly expansionary monetary and fiscal policies might result in the Fed facing conditions similar to those in the 1970s. The Fed would then be forced to choose between two undesirable policies:
“If inflation were to take off, there would be two scenarios: one in which the Fed would let inflation increase, perhaps substantially, and another—more likely—in which the Fed would tighten monetary policy, perhaps again substantially. Neither of these two scenarios is ideal. In the first, inflation expectations would likely become deanchored, cancelling one of the major accomplishments of monetary policy in the last 20 years and making monetary policy more difficult to use in the future. In the second, the increase in interest rates might have to be very large, leading to problems in financial markets. I would rather not go there.”
In a recent interview, Lawrence Summers of Harvard University, who served as secretary of the Treasury in the Clinton administration, made similar points:
“We have inflation that since the beginning of the year has been running at a 5 percent annual rate. …. Starting at high inflation, we’ve got an economy that’s going to grow at extremely high rates for the next quarter or two. … I think we’re going to find ourselves with a new normal of inflation above 3 percent. Then the Fed is either going to have to be inconsistent with all the promises and commitments it’s made [to maintain a target inflation rate of 2 percent] or it’s going to have to attempt the task of slowing down the economy, which is rarely a controlled process.”
Clearly the pandemic and the resulting policy responses have left the Fed in a challenging situation.
Sources: Federal Reserve Open Market Committee, “Federal Reserve Press Release,” federalreserve.gov, July 28, 2021; Lael Brainard, “Assessing Progress as the Economy Moves from Reopening to Recovery,” speech at “Rebuilding the Post-Pandemic Economy” 2021 Annual Meeting of the Aspen Economic Strategy Group, Aspen, Colorado, federalreserve.gov, July 30, 2021; Wall Street Journal editorial board, “Powell Gets His Inflation,” Wall Street Journal, July 13, 2021; Olivier Blanchard, “In Defense of Concerns over the $1.9 Trillion Relief Plan,” piie.com, February 21, 2012; “Former Treasury Secretary on Consumer Prices, U.S. Role in Global Pandemic, Efforts,” wbur.org, August 22, 2021; and Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org.
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