The economy is in a rut right now, but probably not for long.
Many forecasters think a solid recovery will be under way by the second half of 2021, with lost jobs rapidly returning and consumers going on a spending spree. That has led a few analysts to question whether the $1.9 trillion relief plan President Biden is pushing is really necessary—and warn that it might even be counterproductive by overheating the economy.
Harvard economist Larry Summers caused a kerfuffle recently by arguing the $1.9 trillion plan is too big and could trigger unwelcome inflation. Summers is a Democrat who was Treasury Secretary under President Bill Clinton and a top economist for President Barack Obama. His criticism has forced an intraparty feud among Democrats, with Biden officials such as Treasury Secretary Janet Yellen publicly insisting Summers is wrong.
But Summers highlights a serious concern many economists agree on: the deluge of government money combined with the end of the coronavirus pandemic could produce a surprisingly hot economy, with unexpected consequences. “The combination of these generous benefits with households being vaccinated, households wanting to go spend money and have fun, and pent-up savings will lead to significant increases in demand throughout the economy,” says economist Michael Strain of the right-leaning American Enterprise Institute. “The economy’s going to go through a process of reallocation.”
Widespread inflation hasn’t been a problem since the late 1980s, at least, and there have been many mistaken warnings of its return. Globalization and digitization have tamped down prices on many products and services for the last 30 years. So there are good reasons to be skeptical of looming price spikes.
But inflation doesn’t have to ravage household budgets to cause a problem. It just needs to exceed the Federal Reserve’s inflation target of around 2% for awhile. If the Fed felt inflation was getting too high, and likely to stay there, it would have to start tightening monetary policy sooner than markets expect, which could, in turn, stifle the recovery. That’s the one-two punch Summers is worried about.
So the real question is whether too much stimulus spending could cause inflation beyond what the Fed is willing to tolerate. There’s no clear answer, because the government has never in modern times pumped as much money into the economy as it has in the last year. Through several relief and stimulus measures, Congress has so far injected more than $4 trillion into the economy. If Biden gets the bill he wants, the total will be closer to $6 trillion. The stimulus bill Congress passed in 2009, amid the Great Recession, was just $787 billion, by comparison.
Many economists now think there wasn’t enough stimulus spending during the Great Recession, which is why it took six years for employment to reach pre-recession levels, and longer for incomes to recover. Congress has gotten the message, though, with five times as much stimulus spending during the coronavirus downturn as in 2009. That will reach 7x if the Biden measure becomes law, which seems likely. The 2009 stimulus bill didn’t produce inflation, but it was nowhere near $6 trillion, either.
Economists think consumers will splurge—with or without the next relief bill—as vaccinations become widespread and it becomes safer to leave home. While stuck at home since the beginning of March, Americans have saved an extra $1.3 trillion, and they’re likely to spend a good chunk of that once they can shop freely, travel again and attend events. That surge in demand will inevitably push prices of some goods and services higher.
There have already been some unusual increases in inflation during the last year. Overall annual inflation is just 1.4%, but it’s 5.8% for freight trucking, 6.1% for appliances and 10% for used cars. Home prices are up 11% during the last 12 months. Isolated inflation isn’t typically a problem in a downturn, when overall demand is weak. But demand is strengthening and some sustained price hikes are likely coming.
Forecasting firm Oxford Economics expects an “inflation spike” in the spring, driven by more spending and higher energy prices. But it thinks inflation will then cool off. Still, the firm expects the Biden relief plan to boost GDP about 2.4% by the end of the year, which will lead the Fed to begin reining in monetary stimulus at the beginning of 2022, about a year earlier than it might without the Biden aid package. The Fed could then start raising rates, or tightening monetary policy, in the middle of 2023.
“We will see higher inflation, probably above 2%, for the next 18 months,” says Gregory Daco, Oxford’s chief U.S. economist. “Increased fiscal stimulus should support stronger spending over the course of 2021 and stronger business activity. The question is whether the stimulus could lead to the overheating of the economy. In general, I don’t think it would.”
That’s the outcome Biden is aiming for, and it will require the Fed to hold steady if inflation does exceed its 2% target. Fed Chair Jerome Powell has indicated the Fed could do just that, and with many consumers numb to inflation, it shouldn’t be a hard sell.
