As covid fears vanish and more Americans return to work, Dr Orphe Divounguy argues that the Biden administration would be wise to hit the pause button.
Before COVID-19, experts worried that rising inequality harmed economic growth. The pandemic exacerbated the problem. The low interest rate environment helped the rich get richer while low-income families experienced massive job loss.
In response to the COVID-19 shock, the federal government issued unprecedented levels of stimulus spending that also included sending direct cheques to people who had not lost their jobs and members of affluent households.
As of January 2021, one year after the first COVID-19 case on US soil, even though there were still 10 million jobs missing from the US economy, total household income had already exceeded pre-pandemic levels. This is because the stimulus that has already been provided was large, poorly targeted, and ended up raising the incomes of Americans who did not experience any income loss due to the pandemic.
US President Joe Biden wants more stimulus that will include direct payments and more money to state and local governments whose revenue losses have already been more than offset. The details of the new stimulus package drew some criticism from economic policy giant Larry Summers who argued that US$1.9 trillion would be nearly five times as large as the size of the current economic hole.
With so many Americans left out of the COVID-19 recovery, government support is clearly needed. However, transfers should be targeted to those families who were left behind by the pre-pandemic economy and the public health crisis, not blanket handouts for most households.
In addition, it is clear that public health – most importantly, a successful vaccination programme – should be at the top of the spending list. New investments in education and infrastructure for sustained economic prosperity should also be a priority.
Still, the US$1.9 trillion package is overkill. Additional funding – with no strings attached – to corrupt and inefficient state and local governments, as well as cheques to individuals who did not experience income loss, should not be part of the package. It is also unlikely that the Biden administration will stop there. There are already hints that more spending will follow since the newly elected President intends to make good on campaign promises.
Given the prospects of Biden’s abnormally large stimulus package, progress on vaccine rollouts and pent-up consumer demand, financial markets are concerned that inflation could rise faster than expected. As more Americans return to work - with nearly US$2 trillion in “excess” savings - inflation could rise faster than expected to exceed the Federal Reserve’s target.
Are Inflation Fears Overblown?
Not all price increases are cause for concern. Relative price changes, like inflation, can cause price pressure in an economy but they are short-lived and self-correcting.
Over the long run, inflation is caused by too much growth in the money supply. Economists worry that if consumers interpret increases in specific prices of goods and services as signals of emerging inflation, they will adjust their expectations.
If workers and their employers expect inflation to be higher, they act on those beliefs. Businesses raise prices at a higher rate and workers demand higher wages. If individuals begin to suspect that the government is printing money to cover its increasingly enormous deficits, they will become reluctant to hold on to the paper the government uses to finance its expenditures. That means getting rid of their dollars, thus driving up the prices of goods, services, and eventually wages across the entire economy. Taken together, these expectations and subsequent actions can create a dangerous cycle that results in rapidly rising inflation.
The challenge for policymakers lies in that they can’t directly observe these changes in expectations. However, one measure used to gauge market-based inflation expectations is the break-even inflation rate, calculated by taking the difference between the nominal treasury yields and yields on Treasury Inflation Protection Securities (TIPS). If investors expect higher inflation, they will buy TIPS, driving down yields on TIPS and driving up the break-even rate. The 5-year and 10-year break-even inflation rates have steadily increased to surpass levels not seen in nearly a decade.
While many commentators have been accused of crying wolf too many times, policymakers should not so easily dismiss the potential for higher inflation than we are currently used to. Inflation is a lag indicator and it is debatable whether the experts are very good at predicting it, but it can come like a thief in the night to wreak havoc on unsuspecting households.
Why Ignoring Inflation Risk Can Become A Problem
Inflation reduces real returns to savings. As a result, bondholders will demand higher yields as compensation for the expected loss of purchasing power associated with higher inflation.
Although still historically low, bond yields are rising. If yields were to rise too quickly, they could be disruptive on several fronts. For highly indebted governments, higher interest costs could crowd out the delivery of services and desperately needed new public investments. Businesses would suffer as borrowing costs increase. For individuals, higher mortgage rates would raise the cost of homeownership.
Higher borrowing costs would harm many sectors of the economy. However, low-income households that suffered most during the pandemic would likely be disproportionately harmed.
Mitigating The Threat Means Expanding The Nation’s Productive Capacity
The COVID-19 pandemic and subsequent government closures were disinflationary. Public debt rose mostly due to an unprecedented decline in private-sector demand. Until the most recent proposal – the American Rescue Plan – public spending had primarily focused on mitigating the decline in private demand. Unfortunately, only a fraction of that spending made it into the hands of those who experienced negative income effects from COVID-19.
The unprecedented response by the monetary authority and the federal government has already exceeded the amount of money needed to offset the decline in private demand. Therefore, a US$1.9 trillion spending increase would move beyond support for an ailing economy.
While mass vaccination of Americans and offsetting financial losses for businesses and families who suffered record job loss due to the pandemic are very important priorities, this new round of stimulus has prompted some experts to worry the economy may overheat.
Rather than bailing out profligate state and local governments, the Biden administration should focus the bulk of new spending on expanding the nation’s productive capacity. That means spending on public health to stop COVID-19 and addressing other threats to sustainable growth such as investing in education and skills, fixing America’s decaying infrastructure, reforming an archaic immigration system to increase the size of the workforce, reducing childcare costs, and fighting public corruption.
Without a significant increase in the economy’s capacity to produce goods and services, government spending can put significant pressure on economic resources. All else being equal, the increase in government spending will be inflationary.
If inflation expectations and inflation were to increase sharply, the Federal Reserve would likely have to react by causing interest rates to increase and the US economy would be in a worse place than it was before the pandemic – without the fiscal space for those critically needed investments and services.
Main Street Could Lose Big Again
Presently, there is still much slack in the labour market. However, what if our worst inflation fears are realised once COVID-19 is in the rear-view mirror? After all, we’re in uncharted territory.
A smaller stimulus package focused on keeping the economy on life support seems the right call in the current situation. However, Biden, perhaps too concerned with politics, does not prefer the wait-and-see approach.
While above 2 per cent inflation may come as a policy win for the Federal Reserve after falling short for years, an overstimulated economy could just as easily spiral out of control leading to much higher inflation than anticipated. It would be best for our leaders to remain prudent by not completely ignoring these risks. Otherwise, their actions could end up hurting the exact people they are trying to help.
Dr Orphe Divounguy
Orphe Divounguy is a Senior Economist at Zillow Group Inc. Divounguy is the former Chief Economist at the Illinois Policy Institute. Divounguy is also the founder of the Quantitative Research Group and the co-host of the Everyday Economics podcast. Divounguy’s columns and articles cover fiscal policy, labor economics, and quantitative methods for programme and policy evaluation. Contact: firstname.lastname@example.org. The views presented here do not necessarily reflect the views of his employers.