CAMBRIDGE – Are the United States and other advanced economies experiencing stagflation, the unfortunate combination of high inflation and low growth in output and employment that characterized the mid-1970s? At least in America’s case, the answer is no. What the US is facing now is moderate inflation, without the stagnation part. That recalls the 1960s, not the decade that followed.
True, US headline consumer price inflation rose to an unexpected 6.2% in the year to October, the highest rate since 1991. Few still forecast an early return to 2% inflation, the US Federal Reserve’s long-run target. Inflation is also running at ten-year highs in the United Kingdom (4.2%) and the European Union (4.4%), though it remains low in Japan.
In contrast to the stagflationary 1970s, however, the US recovery since the pandemic-induced recession of 2020 has been strong, judged by GDP and labor-market indicators. Rising demand for goods is confronting supply constraints, including port bottlenecks and chip shortages, resulting in price inflation. Meanwhile, rising demand for labor is encountering a supply of labor limited by the lingering effects of the pandemic. This has resulted in wage inflation.
The US unemployment rate fell from 14.8% in April 2020 to 4.6% in October 2021, which would have been considered close to full employment during most of the last half-century. By contrast, unemployment reached 9% in stagflationary May 1975. Other current indicators point to an even tighter labor market today: the ratio of job vacancies to unemployed workers is the highest on record, as is the quit rate. Wage growth is also up, especially at the lower end of the wage distribution.
Only labor-force participation remains substantially depressed. Some of the decline reflects retirements, but much of it is attributable to COVID-19.
The evidence suggests that the US economy’s problem is not insufficient demand, which monetary and fiscal expansion could address, but rather inadequate supply, which they cannot. In particular, both nominal GDP and direct measures of domestic demand, like real personal spending or retail sales, have resumed their long-term pre-pandemic trends. When demand exceeds supply, a trade deficit and inflation result. We are currently witnessing both.
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These are, in a sense, good problems to have. It is clearly better if both demand and supply are recovering, albeit with demand rebounding more quickly, than for neither to be doing so. The US economy is far ahead of where most thought it would be a year ago. It is also ahead of other countries, such as the Brexit-impacted UK, insofar as GDP is now above its pre-pandemic level.
Monetary policy can do nothing to ease capacity constraints. But these constraints could disappear on their own over the next year, as ports unclog, supply chains re-form, choosier workers successfully match with jobs they want, and supply responds to the high prices of those particular sectors facing acute excess demand.
Rather than resembling the 1970s, therefore, today is perhaps more like the late 1960s, another time of rapid growth and tight labor markets. Consumer inflation reached 5.5% in 1969.
Some worry that today’s moderate inflation will eventually be built into expectations, trigger a wage-price spiral, and come to resemble the high and persistent inflation of the 1970s. This is not impossible, and we should not be complacent about inflation. But it is unlikely that policymakers will repeat mistakes made back then.
Those errors began with increasing government spending to finance the Vietnam War, without the tax revenue to pay for it. They continued in 1971, when Fed Chair Arthur Burns and President Richard Nixon responded to rising inflation with a combination of rapid monetary stimulus and doomed wage and price controls. An overheating economy blew the lid off the boiling pot a few years later, and inflation shot above 12%.
True, the Fed was overly optimistic in its forecasts for inflation this year, expecting price increases to be smaller and more transitory. Larry Summers and Olivier Blanchard got it right back in February, when they correctly predicted that rapid growth would lead to inflation.
But although the Fed’s inflation forecasts were wide of the mark, its actions have arguably not been far off-target. True, the Fed did not expect to start tapering its monthly asset purchases – so-called quantitative easing – 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.
Moreover, markets barely reacted to the November 3 taper announcement, indicating that the (now-reappointed) Fed Chair Jerome Powell had successfully communicated the central bank’s rethinking – in contrast to 1994 and 2013, when investors failed to anticipate the start of tightening cycles. If the Fed starts raising short-term interest rates in mid-2022, that will not catch markets by surprise, either.
President Joe Biden can do relatively little to stem the highly unpopular rise in inflation. He has already intervened to help unclog ports and other supply-chain logistics. Increased vaccination against COVID-19 would boost the supply of labor, for example by keeping children in school, though it is difficult to see what more Biden could do here.
A good way to moderate inflation would be to allow more imports. Former President Donald Trump’s tariffs on many products – including aluminum and steel, and almost all US imports from China – raised prices for consumers. Biden should be able to persuade China and other countries to lower some trade barriers against the US in exchange for removing US tariffs. In any case, trade liberalization could reduce some prices quickly.
Some argue that the new government expenditure envisaged in Biden’s social spending bill would work to raise inflation, either because they disapprove of big government or because a dollar of spending raises demand more than a dollar of tax revenue reduces it. Others think the net effect on inflation will be beneficial (particularly in the longer run), because many of the planned programs, such as universal quality preschool, will increase labor supply.
Regardless of these arguments, the new legislation’s effect on inflation should be minor. Biden’s infrastructure package and proposed social spending should be judged on their own merits. Rising US inflation reflects the economy’s rapid recovery from the COVID-19 recession, which means we should get our heads out of the 1970s.