The inflation threat to a post-COVID economy


With inflation looming, consumers are already beginning to feel price increases hitting their pocketbooks. Federal Reserve chief Jerome Powell has been dismissive of such concerns, even as his refusal to consider raising interest rates is increasing the risk of inflation and a nasty economic landing afterward. And, as always, it will be everyday people who bear the brunt of the financial fallout.

Over the past year, gasoline prices have increased by 9% and food prices by 3.5%. Building materials such as lumber and copper have gone through the roof, and restaurant prices are strongly on the rise. At the same time, unhealthy equity and housing bubbles are forming, and there are growing indications that the U.S. economy could overheat by year-end. Still, Powell keeps repeating that the Fed is “not even thinking about thinking about raising interest rates.”

Among the clearest of indications that the economy is on its way to overheating is President Joe Biden’s excessively expansive budget policies. Following the passage of a $900 billion bipartisan budget stimulus last December, Biden rushed through Congress a $1.9 trillion budget package. This would imply that this year, the economy will be receiving a record peacetime budget stimulus of as much as 13% of GDP.

One reason for fearing that such a large amount of budget stimulus will soon lead to an unwelcome surge in prices is that this spending is coming at a time when the economy is already well on its way to recovery and there are widespread signs of price pressures building up. In March, consumer prices were increasing by more than 2.5%, and 5-year inflation expectations, as measured in the bond market, were in excess of the Federal Reserve’s 2% inflation target.

The Congressional Budget Office estimates that U.S. economic output is only 3% short of its potential. Biden’s massive spending push is also occurring at a time when households have built up a record amount of savings during the pandemic. One must now expect that these excess savings will be spent once most are vaccinated and the country returns to some semblance of normality.

Far from countering the building inflationary pressures from Biden’s budget largesse, the Federal Reserve seems to be adding fuel to the fire. It is doing so by keeping interest rates at ultra-low levels and by continuing to buy U.S. Treasury bonds and mortgage-backed securities in the amount of $120 billion a month. The net result of the Fed’s ultra-easy monetary policy stance is that the national broad money supply is now growing by close to 30%, which is, by far, its fastest rate in the past 60 years.

After years of studying inflation, Milton Friedman famously concluded that inflation is always and everywhere a monetary phenomenon. If there is any truth to Friedman’s dictum, Powell should have yet another reason to be concerned that inflation could be around the corner.

Even after the country’s painful experience in 2008 with the bursting of the housing and credit market bubble, the Fed seems to be unfazed by the asset price and credit market bubbles forming both at home and abroad. In particular, it seems to have escaped the Fed’s notice that U.S. equity valuations today are already at the lofty levels last experienced on the eve of the 1929 stock market crash. The Fed also seems to be turning a blind eye to the fact that over the past year, U.S. house prices increased by 12% — or by their fastest pace since 2006.

William McChesney Martin once observed that the Federal Reserve’s job was to remove the punch bowl just when the party was warming up. Evidently, Powell’s Fed does not subscribe to this view. Even as the economy is now set to grow at its fastest pace in the past 40 years, and during a year in which equity prices have increased by a record 85%, Powell’s Fed continues to spike the punch bowl with its extraordinarily easy monetary policy stance.

Ominously, the Fed also does not seem to subscribe to Friedman’s view that monetary policy operates with long and variable lags. Instead, it thinks that it can afford the luxury of waiting until the clearest of inflation indications emerge before dealing with the inflationary pressures now building up in the economy. By so doing, it risks falling well behind the inflation curve.

All of this does not bode well for the Fed achieving its dual mandate of stable prices and high employment. By maintaining its ultra-easy monetary policy at a time of record peacetime budget spending, it risks well exceeding its inflation target by the end of this year. That would constitute a particular burden on the poorer part of the population, who are least able to defend themselves against inflation and who are already beginning to see increased prices on some everyday items such as food and gasoline. By then, being forced to slam on the monetary brakes to meet its inflation objective, Biden and his Fed risk bursting the asset price bubble next year with all-too-likely untoward consequences for economic growth and employment.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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