PROFESSOR�S NOTE

PROFESSOR’S NOTE

Davis Mascio

PROFESSOR

The U.S. economy has recovered from the COVID-19 lockdowns in 2020 primarily because of “loose” monetary and fiscal policy. Inflation at the consumer level increased by 5.6% in 2021.

The economic environment within the United States in 2021 can be characterized by unprecedented monetary and fiscal policy expansion. The U.S. unemployment rate held steady between 3.5% - 4.0%, the S&P 500 Stock Index finished the year at an all-time high near 4,800, and the U.S. economy grew by 7.0%. This current expansion is long in the tooth and will likely move in the opposite direction because of the significant increase in inflation.

The U.S. economy has recovered from the COVID-19 lockdowns in 2020 primarily because of “loose” monetary and fiscal policy. Inflation at the consumer level increased by 5.6% in 2021, which is a two-decade high. Most economists (including this one) believe the rapid rise in energy costs, increasing home prices and supply constraints will drive core inflation to levels we have not seen since the 1970s and early 1980s.

The more important question is how monetary and fiscal will work together to combat higher levels of inflation. At the end of 2021, the overnight lending rate remained between 0.00% and 0.25%, while the benchmark 10-year U.S. Treasury Note yield stood near 1.5%. The Federal Reserve Bank has been highly accommodative, which will ultimately result in considerable inflationary risk going into 2022. Both Janet Yellen (U.S. Treasury Secretary) and Jerome Powell (Federal Reserve Chairman) have stated that the current level of inflation is merely a result of the reopening of the overall economy. In addition, they believe inflation will abate by mid-year 2022.

The Taylor Rule, which is the annual inflation rate divided by the benchmark interest rate (1.5/5.6 = 0.267) suggests the central bank and the U.S. Treasury are behind the curve in controlling future inflation. Ideally, this ratio should be at 1.5, not 0.267. The benchmark interest rate should not be below the current inflation.

So, why has the central bank been slow to raise interest rates? In short, it believes this current inflation spike is temporary due to the fact manufacturing output has not kept up with consumers re-opening demand from the lockdowns in 2020. Therefore, this problem will fix itself with time. More dovish economists believe the high current levels of inflation are

“transitory” and will subside later in 2022. Either way, the central bank needs to allow interest rates to increase at every maturity along the yield curve to ensure that inflation does not become a major problem in 2022 and into 2023.

To conclude, 2021 will go down as one of the most significant economic expansionary periods in modern times, fueled by unprecedented amounts of government spending and extraordinarily low interest rates. Unfortunately, the entire global economy will have to deal with high levels of inflation in the years to come because central bankers and the Treasury Department have been slow to react to the current inflationary environment.