Taming Inflation: What Policymakers Can – and Should – Do

Taming Inflation:

What Policymakers Can – and Should – Do

by DOUGLAS HOLTZ-EAKIN

The shocking acceleration of inflation is the economic signature of 2021. In January, year-over-year Consumer Price Index (CPI) inflation was 1.4 percent; by December it had shot to 7.0 percent. Even more striking, prices for food, energy, and shelter – which constitutes over 50 percent of the typical family budget – had skyrocketed by 8.2 percent.

The 5.7 percentage point 12-month jump in CPI inflation has been exceeded only twice in the postwar era: In 1951, it jumped as much as 10.6 percentage points, and in 1974, it rose 6.1 percentage points. Both episodes are instructive.

The 1951 episode is a cautionary tale about overstimulating the economy. In this case, year-over-year growth in gross domestic product entered the year in double-digit territory and Korean War-related defense production layered on yearover-year growth in government spending that peaked at 49 percent in the third quarter. Lesson: Excessive government spending in a hot economy can quickly fuel inflation.

In contrast, the 1974 episode demonstrates the exact opposite of demand stimulus. Instead, it features a huge supply cost shock – the quadrupling of oil prices due to the OPEC oil embargo. Lesson: Cost increases borne by supply problems can quickly be passed along to consumers, even if the economy is moving toward recession.

The inflation of 2021 reflects a combination of these forces. The COVID-19 pandemic has wreaked havoc on labor markets worldwide, and the resulting disruptions in supply chains and goods production have been welldocumented. These supply constraints increased costs and generated higher inflation across the globe. European consumer price inflation, for example, increased about one

percentage point each quarter and ended 2021 at 4 percent. Part of the U.S. experience is driven by supply chain issues, as well. But the U.S. government added fuel to the fire, passing the $1.9 trillion, deficit-financed American Rescue Plan stimulus in March 2021. At the time of its signing, the U.S. economy was growing at a red-hot 6.5 percent; additional stimulus was neither needed nor desirable. Inflation responded immediately to the policy error, jumping from 1.9 percent in the first quarter to 4.8 percent in the second quarter – nearly three times the increase of Europe’s supply-driven inflation. The fiscal stimulus was reinforced by an aggressively accommodative monetary policy that featured zeropercent interest rates and large, continuous monetary infusions. Inflation continued to rise as the year went on. Douglas Holtz-Eakin Inflation is clearly a problem in the present. Will it continue? To be durable, price inflation must

Perhaps the best we can be accompanied by wage inflation hope from policymakers is and higher inflation expectations. that they stop adding to the Wage inflation has already arrived, as average hourly earnings rose 5 problem with massive new percent from December 2020 to spending bills, such as the December 2021. To compound

Build Back Better Act. matters, consumers’ expectations for inflation over the next year rose from 3 percent to 6 percent during 2021. This raises the specter of workers bargaining for higher wages as a hedge against expected inflation. When those labor cost increases get passed on to consumers, the expected inflation becomes a self-fulfilling prophecy. What should policymakers do? To diagnose the roots of this inflation is to identify the appropriate policy response. Ultimately, the supply chain issues boil down to the impact of the coronavirus. This is best offset with a more effective public health

policy. Both administrations have botched the response to such as the Build Back Better Act. COVID-19 with reliance on vaccines as a silver bullet. It Most of the focus is thus on the Federal Reserve, is not surprising that, as The New York Times reported, six which must take its foot off the monetary accelerator and former Biden transition advisers called on the president “to begin tapping the brakes with higher interest rates and adopt an entirely new domestic pandemic strategy geared withdrawals of the massive monetary infusion undertaken to the ‘new normal’ of living during the pandemic. If it with the virus indefinitely, not taps too lightly, inflation will to wiping it out.” The Federal Reserve … must persist and become more Such a strategy would be composed of a greater range take its foot off the monetary acentrenched. If it becomes too aggressive—as has habitually of responses to the pandemic, celerator and begin tapping the been the case in its postwar with more emphasis on testing and therapeutics, and less brakes with higher interest rates response to sharp rises in inflation—growth will stall, on mandates for lockdowns, and withdrawals of the massive and a recession could ensue. vaccines, and masks. monetary infusion undertaken Inflation is the top There are, of course, traditional tools of economic during the pandemic. economic issue this year but is largely attributable to policy available to slow Washington’s policy errors in the excess stimulus that is the past year. Policymakers contributing to inflation. It is highly unlikely, however, will have to raise their game in 2022 to tame inflation that policymakers will soon embark on structural deficit without damaging the recovery. RF reduction via higher taxes and lower spending. Perhaps the best we can hope from policymakers is that they stop Douglas Holtz-Eakin is the President of the American adding to the problem with massive new spending bills, Action Forum.