It is always annoying to have to admit one has been wrong. But I was among those who a year ago or so was going along with those who argued inflation was transitory and the rate would probably come down later in the year. The annoying Larry Summers, along with the somewhat less annoying Olivier Blanchard, prominently argued the contrary, hauling out old-fashioned conventional macroeconomic arguments why this might be the case, replete with implicit Phillips Curves and the like. A major focus was the Biden administration’s American Rescue Plan (ARP) fiscal stimulus and its large budget deficits aimed to help pull the US economy further out of the pandemic recession, but hopefully without stimulating inflation. As it turns out, the critics were right, and while the economy has grown vigorously, inflation has not only not gone down, but it has accelerated.
Obviously part of this is due to things that neither Summers nor Blanchard could foresee, two more rounds of pandemic (with arguably a third now coming on), with these aggravating the supply chain problems that played a prime role in the initial rise of inflation, and which those of predicting a decline in inflation saw as easing. And then we got Putin’s invasion of Ukraine that has seriously aggravated supply side problems further in both energy and food as well as some other resource inputs such as nickel. The new round of Omicron B.2 also is hitting China, with lockdowns shutting ports and further keeping supply problems going. Supply side problems on the inflation front look likely to persist certainly through the rest of this year, even if longer range forecasts in markets still see the rate returning to the old target 2 percent range some years in the future.
Needless to say, these supply chain and side problems affect global inflation, not just that in the US. Can we distinguish the effect of more recent fiscal stimulus in the US on its inflation that Summers and Blanchard highlighted with its impact on demand on top of these global supply problems? One indicator may be a comparison with the euro area. It has experienced most of these supply problems similarly to the US. It is also the case that both engaged in large fiscal stimulus in 2020 during the initial onslaught of the pandemic when the global economy eventually plunged through the floor. But the euro area held back on this extra fiscal stimulus last year while the US roared ahead.
The crude numbers in comparison tell a Phillips Curve story. On the one hand indeed inflation in the US is now about 2% higher than in the eurozone; 7.9% compared to 5.9%. But the unemployment rate in the US is much lower: 3.8% compared to 6.8%. The difference in growth rates has not been all that sharp, although indeed the US has been faster over the past year: 5.6% to 4.6%. As for fiscal budget balances, the US is in a much more substantial budget deficit situation with it at -7.4% of GDP compared to -4.1% in the eurozone.
Of course, the ARP has nearly run its course, although in Harrisonburg where I live the city is just now debating what to do with the extra $24 million it received as part of the ARP package. The money may have been allocated, but it has not yet been spent. In any case, the new budget just proposed by Biden looks to cut the budget deficit roughly in half, although I expect that Congress will not have it do so by quite that much, especially as it will probably not go along with some of the tax increases proposed in the budget. But if indeed the budget deficit were to be cut in half, that would put the US budget balance in line approximately with what one sees currently in the eurozone.
I close by noting that in recent years the US had one extra round of fiscal stimulus that was almost certainly not needed and did not have an equivalent in the eurozone, even if it did not set off an inflation increase at the time. This was Trump’s tax cut for the well off that happened early in his administration, unaccompanied by any spending cut, and that happened at a time when the US economy was nearing a full employment level. Biden’s new budget proposal only partially attempts to undo that unnecessary and unuseful tax cut, but does not do so full, and very likely even the slight moves to do so proposed in the budget will not make it through the Congress.