Between the late 1960s and early 1980s, inflation was America’s single biggest and most persistent economic problem. As former Washington Post columnist Robert Samuelson has written, “Terrified Americans didn’t know how high it would go or whether their wages and savings would keep pace.” Presidents of both parties tried to control it, without much success. Federal Reserve officials seemed unable or unwilling to implement the necessary monetary tightening.
All of that changed during the tenure of Fed Chairman Paul Volcker, who raised interest rates to previously unthinkable levels while receiving crucial support from President Reagan. Volcker eventually conquered inflation, but only after a brutal recession in 1981 and 1982 that saw unemployment surge to what was then a postwar high of 10.8 percent.
For a certain generation of policymakers, the Great Inflation represented a scarring, transformative experience that shaped their worldview for decades. Nobody wanted to repeat the mistakes of the 1970s. Everyone knew firsthand how galloping price increases could ravage the economy.
A younger generation of policymakers have grown up during an era of remarkably low inflation. To them, the Great Inflation might as well be ancient history. They recall how, in 2010, various economists, investors, scholars, and pundits warned that the Fed’s quantitative-easing program could lead to “currency debasement and inflation.” Today, many critics of President Biden’s $1.9 trillion American Rescue Plan similarly fear that it will push inflation risks into dangerous territory.
The inflation worriers were wrong in 2010. Are they wrong again in 2021? Greg Ip of the Wall Street Journal recently provided a balanced overview of the debate.
“For most of the past 25 years,” he noted, “inflation has run close to or below 2%, even when GDP was above potential and unemployment was below its natural rate.”
How do we explain that?
Ip cited three factors. First, people have gotten used to low inflation—i.e., a rate around 2 percent—which means they don’t expect it to spike even during a hot economy. Second, globalization and technology have suppressed inflation, and societal aging has reduced GDP growth. Third, our economic potential might be higher, and the “natural” unemployment rate lower, than policymakers had previously thought.
Persistently low inflation carries risks of its own. Moreover, when the Fed repeatedly undershoots its 2 percent target—as it has in recent years—that’s a sign that monetary policy is too tight. In August 2020, the Federal Open Market Committee updated its consensus statement to announce that, when inflation stays below 2 percent for an extended time, the central bank will seek to overshoot the target in the short term to help deliver an average rate of 2 percent in the long term:
“The Committee judges that longer-term inflation expectations that are well anchored at 2 percent foster price stability and moderate long-term interest rates and enhance the Committee’s ability to promote maximum employment in the face of significant economic disturbances. In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time” (emphasis added).
During the economic boom that preceded the COVID-19 pandemic, unemployment fell to its lowest level since 1969, and unemployment among blacks and Hispanics hit all-time lows. Yet as Fed Chairman Jerome Powell observed in a speech last month, “Inflation did not even rise to 2 percent on a sustained basis. There was every reason to expect that the labor market could have strengthened even further without causing a worrisome increase in inflation were it not for the onset of the pandemic.”
Given this history, it’s understandable that many experts do not believe the American Rescue Plan poses any significant inflation risks.
“Neither markets, the Fed nor most economists think it will push inflation meaningfully above the Fed’s target,” Ip wrote in his Journal article. “They argue, for example, that as the fiscal boost expires next year, the upward pressure on spending and therefore on prices will recede. Economists surveyed by the Journal see [Consumer Price Index] inflation at 2.2% at the end of 2023.”
Case closed? Not quite.
As Ip added, “Some influential economists disagree; they say Mr. Biden’s stimulus is so large it will push the U.S. past any reasonable estimate of the economy’s potential output, which could boost inflation much higher than the Fed wants.”
Perhaps surprisingly, one of those economists is Larry Summers, who served as Treasury Secretary in the Clinton administration and National Economic Council Director in the Obama administration. Writing in the Washington Post last month, Summers issued a warning about the $1.9 trillion spending bill:
“While there are enormous uncertainties, 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. This will be manageable if monetary and fiscal policy can be rapidly adjusted to address the problem. But given the commitments the Fed has made, administration officials’ dismissal of even the possibility of inflation, and the difficulties in mobilizing congressional support for tax increases or spending cuts, there is the risk of inflation expectations rising sharply.”
As Summers explained in a follow-up column, he does not object to the size of the stimulus per se; he objects to its composition.
“In my view,” Summers wrote, “there is nothing wrong with targeting $1.9 trillion, and I could support a much larger figure in total stimulus. But a substantial part of the program should be directed at promoting sustainable and inclusive economic growth for the remainder of the decade and beyond, not simply supporting incomes this year and next. An approach of this kind, spending out more slowly, will reduce possible inflation pressures and also increase the economy’s capacity. We will be borrowing to finance sound investments rather than consumption.”
When discussing inflation, it’s important to specify which kind we’re talking about. Even many people who are not worried about consumer-price inflation have raised concerns about asset-price inflation—that is, the creation of financial bubbles.
“The Fed defines its inflation target in terms of consumer prices, such as those we pay for cars, toothpaste and haircuts,” the Wall Street Journal’s Jon Hilsenrath wrote recently. “But in recent decades, prices have often climbed much faster for investment assets, such as homes and stocks, and twice led to booms and busts followed by recessions.”
Indeed, the infamous pre-2008 housing bubble emerged during a period when consumer-price inflation remained relatively low. It’s still low today, but stock markets and home prices have soared.
Should the Fed try to deflate potential asset bubbles before they generate a crisis? In September, Chairman Powell said that “monetary policy should not be the first line of defense” for upholding financial stability; instead, the first line of defense should be macro-prudential regulation, such as liquidity and capital requirements and stress testing.
That’s a fair point. After all, as Hilsenrath reminded us, “One of the lessons of the past two asset price booms was that it was hard to identify the bubble while it was inflating and even harder to stop it without creating collateral economic damage.” The current housing-price boom could be just “a passing phenomenon” triggered by the pandemic, as Chairman Powell suggested in January. (We now have much stricter lending standards than we did before 2008, which makes the present housing surge less risky to the broader financial system.)
Either way, we should remember that low consumer-price inflation and high asset-price inflation can occur simultaneously.
Former New York Fed President Bill Dudley has argued that, while consumer-price inflation “is likely to head higher,” we also have “plenty of reasons to believe that things won’t get out of hand, at least not quickly.” Yet even the mostly benign scenario that Dudley describes would “leave U.S. interest rates higher than they’ve been in a long time.”
Why would that matter? Well, the Congressional Budget Office has projected that federal debt held by the public will increase from 102 percent of GDP in 2021 to 202 percent of GDP in 2051. (By comparison, it has averaged just 44 percent of GDP over the past half century.) Right now, our massive debt is relatively cheap to service because interest rates are so low. If rates jumped significantly, debt service would become far more expensive.
In 2021, neither Democrats nor Republicans have any credibility as fiscal hawks. Unfortunately, the debt problem is not going away—and higher interest rates would make it worse.