In a recent article by the US News, Jerome Powell, Chair of the Federal Reserve, stated that despite the anticipated growth in inflation in the coming months, the Federal Reserve will maintain its low-interest rate policies (“Powell”), citing that such inflation is likely to be temporary. Should we be more worried than Powell is about this? While what Powell says may be true, let us dive a bit deeper to understand why his lack of concern may be well placed concerning potential future inflation. To begin, we shall investigate the actions of Powell’s Federal Reserve as of recent, altogether what can be defined as monetary policy. Until the pandemic started in March 2020, the Federal Reserve was gradually increasing the federal funds rate (from here on referenced as interest rate), but reversed course by decreasing interest rates rapidly in response to the economic downturn caused by the pandemic.
(“Effective Federal Funds Rate”)
This lowering of the interest rate is called expansionary monetary policy, which means that it encourages economic growth. A model that can be used for understanding this is the IS-LM model, which models the interaction between the goods and financial market. The LM curve is a horizontal line that represents the interest rate. During expansionary monetary policy, when the interest rate decreases, the LM curve shifts down:
(Blanchard 98)
The downward shift in the LM curve increases equilibrium output. The Federal Reserve changes the interest rate by changing the money supply. To do so, the Federal Reserve buys bonds, paying for them with printed money, which then increases the money supply—the nominal amount of money within the economy (Blanchard 74). This lowers the interest rate as, with a greater supply of money but (all else equal) the same demand for money, the cost incurred by someone who takes on a loan (such as the interest rate) decreases as competition for the supply of money is eased (Blanchard 72).
Another component for us to understand in our analysis is not only monetary policy, as just mentioned, but also fiscal policy. President Biden recently signed a $1.9 trillion pandemic relief bill, which has within it a $1400 direct payment to individuals that make under $75,000 a year (Pramuk). Government transfers, such as these stimulus checks, do not directly contribute to economic growth in the form of increasing GDP. They do, however, impact consumption expenditures, which is a large component of GDP (Blanchard 49-52). This is because these transfers increase individual disposable income, which in turn allows for increased consumption. Individual marginal propensity to consume, which is the effect an additional dollar of disposable income has on consumption (Blanchard 51), is currently around 50% (Karger & Rajan). This value indicates that the stimulus checks will then likely have a large impact on consumption expenditures, and in turn, GDP. Additionally, households with low levels of liquidity (ability to turn current assets into money quickly) or who are lower-income tend to positively change their consumption levels more strongly in response to stimulus checks than other households (Baker et. al. 4). Thus, as these stimulus checks roll out, we should not only expect that an increase in output would happen as people have more money, but that they spend a good amount of it (50%). Furthermore, there are likely many households way above this due to low levels of liquidity and have also become lower income due to turbulence in the unemployment rate over the past year (14% in March 2020 and approximately 6% in February 2021) (“Civilian unemployment rate”), that these stimulus checks will be reinvested heavily into the economy, and allow for many revolutions of continual reinvestment throughout. While monetary policy shifts the LM curve, an expansionary fiscal policy like the stimulus checks shifts the IS curve right-ward. Essentially, the checks act as ‘negative taxes’ to income, which shows an increase in output at any interest rate. The following graph demonstrates this outward shift in conjunction with the downward shifting LM curve due to expansionary monetary policy:
(Blanchard 99)
Now that we have covered both the recent monetary and fiscal policies (the combination of the two is called a policy mix) enacted in response to the economic downturn of the pandemic, we now have context for adequately answering our question: should we be more concerned about inflation? The Federal Reserve targets an inflation rate of 2% (“How much”); in February, the rate rose to approximately 1.7% (some of the inflation effects are due to decreased prices last year) (“How much”). The expansionary policies, especially the stimulus checks, create the possibility for a large consumer expenditure boom that could create more inflation. Referencing our textbook, we can consider this in the context of two concepts: Okun’s Law and the Phillips Curve. Per Okun’s Law, should the economy grow, the change in the unemployment rate goes down, eventually leading to a negative change in unemployment somewhere around 3% output growth (Blanchard 34). On the Phillips Curve, should unemployment decrease significantly, we would then see a rise in inflation (Blanchard 35). This is where the concern lies: that should the economy ‘overheat’ due to two large expansionary policy measures, there could be significant inflation. The Federal Reserve, however, can respond to inflation by implementing a contractionary monetary policy that increases the interest rate. In the IS-LM model, this would shift the LM curve upwards, thus decreasing equilibrium economic output. This is because when interest rates are higher, taking loans would cost more, leading to fewer loans being taken overall, and fewer projects are taken on which could have had net benefits at lower costs. As this lessens economic output, it would have the opposite effect on inflation as our policies earlier: it would lower inflation. The consequential reduced economic output is a significant tradeoff; it would result in increased unemployment, leading to individuals losing their jobs and households losing their income. This could potentially extend or recreate the recession we are currently in. Therefore, The Federal Reserve may not choose to intervene unless the inflation rate reaches 2%, instead prioritizing economic growth for the time being. If the Federal Reserve does choose to increase interest rates in the future in response to a large consumption expenditure boom, there remains the potential for increased economic output in comparison to the recession of 2020. As we are coming out of a pandemic, however, and are attempting to combat its negative economic effects, consider a few things: (1) with the worst likely over, consumers may come to accept such contractionary policies as the worst darkness (social isolation, unemployment etc.) has passed, and (2) as the contractionary policy would coincide with fiscal policy, it could very well be a net growth over time in economic output while implementing such a contractionary policy:
Additionally, it would not simply be a decrease in economic output to stave off inflation, but would be done within an expansionary era. In essence, not only does the Federal Reserve think inflation will be temporary, but the Fed has tools to combat it, tools which, though (perhaps) less accepted in prior times, may lead to less social upheaval now than it would have after only the 2008 recession.
Bibliography
Baker, Scott, et. al. “Income, Liquidity, and the Consumption Response to the 2020 Economic Stimulus Payments.” National Bureau of Economic Research, 15 Sept. 2020, nber.org/system/files/working_papers/w27097/w27097.pdf Accessed 18 Mar. 2021.
Blanchard, Olivier. “Macroeconomics.” 7th edition, Pearson Education, Inc., 2017. Accessed 18 Mar. 2021. “Civilian unemployment rate.” Graphics for Economic News Releases, U.S. Bureau of Labor Statistics, bls.gov/charts/employment-situation/civilian-unemployment-rate.htm. Accessed 18 Mar. 2021.
“Effective Federal Funds Rate.” Economic Research, Federal Reserve Bank of St. Louis, fred.stlouisfed.org/series/FEDFUNDS. Accessed 18 Mar. 2021.
“How much of a worry is inflation?” The Economist explains, The Economist, economist.com/the-economist-explains/2021/03/11/how-much-of-a-worry-is-inflation. Accessed 18 Mar. 2021.
Karger, Ezra, and Aastha Rajan. “Heterogeneity in the Marginal Propensity to Consume: Evidence from Covid-19 Stimulus Payments (REVISED October 2020).” Federal Reserve Bank of Chicago, May 2020, chicagofed.org/publications/working-papers/2020/2020-15. Accessed 18 Mar. 2021.
“Powell: Higher Inflation Temporary, No Rate Hikes in Sight.” US News, 4 Mar. 2021, usnews.com/news/business/articles/2021-03-04/powell-higher-inflation-temporary-fed-will-be-patient. Accessed 18 Mar. 2021.
Pramuk, Jacob. “House passes $1.9 trillion Covid relief bill, sends it to Biden to sign.” CNBC, 10 Mar. 2021. Accessed 18 Mar. 2021.
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