The Short March Back to Inflation

Date: 04‑02‑2021

Source: The Wall Street Journal By Michael D. Bordo and Mickey D. Levy

Like today, policy makers of the 1960s had bigger worries than prices. Then a spike crushed the economy.

There is a long history of high budget deficits being associated with inflation, and Washington’s current profligate spending and the Federal Reserve’s expansive monetary policy may be pushing the U.S. down that path. In the U.S. and world‑wide, the link between deficits and inflation has been most apparent during wartime, as the fiscal burdens of combat spur central banks into inflationary financing. But there are also peacetime instances. Now, after a decade of modest inflation that has made many expect it will always stay low, a rise in inflation may come as a surprise.

Sounding the alarm about inflation is out of vogue. Skeptics point out that high deficit spending, zero interest rates and unprecedented quantitative easing didn’t spur inflation in the decade after the 2008‑09 financial crisis. That experience has left a strong impression on makers of monetary and fiscal policy.

But the government response to the pandemic is dwarfing the actions that followed the financial crisis. Fiscal initiatives since last March have already authorized deficit spending equal to 17% of gross domestic product. Generous government transfers to individuals and businesses have supported household incomes and will stimulate aggregate demand for years to come. President Biden now proposes additional deficit spending equal to roughly 9% of GDP. These total deficit increases are magnitudes larger than President Obama’s American Recovery and Reinvestment Act of 2009.

Combined with the Fed’s expansive monetary policy, the government’s income supports have generated a surge in money supply and excess household savings. Even before the latest Treasury distribution of $600 checks, much less the new round of checks Mr. Biden proposes, personal savings were an estimated $1.5 trillion higher than pre‑pandemic levels. That contrasts sharply with the Fed’s post‑financial‑crisis quantitative‑easing programs, which only generated excess reserves that sloshed around between big banks and the Fed and were never put directly to work in the economy. The widespread administering of vaccines is now set to release the constraints of the pandemic and unleash the unprecedented pipeline of fiscal and monetary stimulus.

A few episodes from history stand out as parallels. After World War II, concerns that aggregate demand would slump and the economy would shrink led the Treasury to pressure the Fed to maintain its artificially low interest‑rate pegs. Contrary to expectations, a surge of pent up household savings and massive Fed liquidity resulted in strong economic growth, and inflation—up to 15% a year by 1948.

After the relatively flat 1950s, inflation returned in the mid‑1960s and depressed economic performance for a decade and a half—an illustration of how money supply ebbs and flows. The Fed accommodated deficit spending for the Vietnam War expansion and Great Society, and President Lyndon B. Johnson pressured the central bank to keep interest rates low. The Fed spent the following years trying to curb the resulting inflation but was reluctant to hike rates out of fear of hurting employment, its true priority. The result was abysmal economic performance with high inflation and unemployment, the opposite of the outcomes predicted by the Phillips curve.

Things were worse in the U.K., where belief in the primacy of Keynesian full employment and powerful trade unions bound successive governments to keep interest rates low. Under the pegged exchange rates of the Bretton Woods system, the loose money and heated economy caused a balance‑of‑payments crisis that eventually cooled the economy down. Once the U.K. abandoned the fixed peg in 1972, there was no check in place to prevent inflation from accelerating.

Although every experience of high deficits accompanied by inflation is different, a common theme is the initiative of fiscal policy makers, who run high deficits and occasionally pressure central banks to keep interest rates low. This time the Fed hasn’t needed any nudging. The periods of inflation that followed every major U.S. war show that normalizing both fiscal and monetary policy after emergency responses is critical to healthy economic performance. Maintaining stimulus longer than needed usually creates costs that go beyond the short‑term federal balance sheet. The sustained moderate inflation of the past decade is a counterexample, but it would be risky to assume it’s the new rule.

The government’s emergency income support to individuals and businesses has been an appropriate response to blunt the shock of the pandemic. Fiscal and monetary policies have shifted to boost employment as firmly as possible. But policy makers must take account of where things stand now and how far they’ve pushed the dials. If the vaccines are successful, full economic recovery will naturally unfold, and the emergency policies that helped sustain the country during the crisis will prove excessive once the economy normalizes. History is longer than the past 10 years, and its lesson is that the risk of inflation ought not be taken lightly.

Mr. Bordo is a distinguished professor of economics at Rutgers University and a visiting fellow at Stanford’s Hoover Institution. Mr. Levy is senior economist at Berenberg Capital Markets. Both are members of the Shadow Open Market Committee.