Introduction

Prices today are rising at their fastest pace in decades and American concern about inflation is growing. While some amount of inflation can be the result of a healthy and growing economy, rapid, sustained inflation harms American families by wiping out their wage gains and eroding savings. Inflation can also rock consumer confidence, which hurts U.S. businesses endeavoring to rebuild after the pandemic recession.

Considerable debate exists over whether recent inflation is transitory or if it is a more concerning type of systemic inflation. On one hand, inflation might be a temporary phenomenon caused by the reopening of the global economy. The United States is ahead of many other nations in its recovery and supply chains are taking time to recover from over a year of sustained disruptions. On the other hand, rising inflation may be the direct result of government stimulus, which significantly increased household income and demand at a time when labor markets and other business functions remain below their pre-pandemic strengths.

After surveying the evidence, this paper concludes that rising prices are likely a mix of transitory inflation and more lasting inflation caused by government stimulus. While increased costs for American producers will likely subside after global supply chains adjust, demand-driven inflation may be exacerbated even further if government stimulus continues to boost household income before the labor market recovers. Tax increases that further constrain business activity could also make inflation worse.  

Background

Faced with an unprecedented pandemic and economic downturn in 2020, the federal government responded with an unprecedented fiscal and monetary response. Since the pandemic began, Congress has authorized $6 trillion in new spending as part of the American Rescue Plan, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, and other legislation. The Federal Reserve has simultaneously purchased over $4 trillion of new assets to inject capital and liquidity into the market. In turn, federal debt rose substantially and is currently equal to the size of the economy, standing at almost 100 percent of GDP.

The Federal Reserve’s monetary response was swift and has been sufficiently accommodative, especially combined with Congress’s initial pandemic aid that helped stabilize household income during the worst of the recession. After multiple spending packages, these measures ended up overcorrecting for the downturn by boosting income and savings above what they would have been absent a pandemic.

Yet, over a year after the recession officially ended, Congress continues to pursue massive new government spending measures—including a $3.5 trillion budget resolution, the single largest spending package in history.

If legislators continue pushing government spending to new heights, they should be aware of the costs. These costs go beyond the simple sticker price of new spending. For instance, government investment has well-demonstrated opportunity costs and in many cases replaces relatively more productive private investment to the point that the private sector shrinks.

Furthermore, large government spending packages are usually accompanied by tax increases which reduce economic growth by depressing employment and investment. One study finds that, if the $3.5 trillion budget resolution boosts productivity in line with historical norms, the effect of the corresponding proposed tax increases eliminate any benefits of the government investment, decreasing economic growth only five years after its enactment.

Lawmakers should also be aware of the additional risks that swelling government spending poses to American families. The most pressing risk today is rising inflation. While monetary tightening serves as the traditional tool to prevent inflation, future monetary tightening may not be effective if extraordinary spending patterns continue.

Inflation is Rising

By two common price metrics, inflation is rising at the fastest paces since the early 1990s. In August, the Core Consumer Price Index—which tracks the prices of commonly-purchased goods excluding volatile items in the food and energy sectors—increased 4 percent year-over-year. Likewise, the most recent Core Personal Consumption Expenditures Price Index—which tracks actual spending by households on items excluding food and energy—rose 3.6 percent.

Although inflation has stopped accelerating in recent months, it remains significantly above the Federal Reserve’s 2 percent target. Furthermore, the recent cooling is largely driven by consumer anxiety about the Delta variant which has reduced consumer demand for transportation and travel. Increasing anxiety is neither a laudable nor sustainable approach to reducing inflation.

If high inflation persists, it will harm American families by decreasing their purchasing power. In the first quarter of 2021, the rise in consumer prices effectively erased all  nominal wage gains causing real earnings to fall. Recent measures of consumer sentiment have also dropped significantly, with surveys showing that Americans are increasingly concerned about inflation.

What Causes Inflation?

To better understand whether this rising inflation is simply a temporary phenomenon or the direct result of government intervention, it is important to first understand two different types of inflation.

The first is cost-push inflation, which happens when the cost of production rises. Cost-push inflation can occur if businesses are faced with sudden rising prices for raw materials, intermediate goods, or labor, and pass those higher costs on to consumers. This type of inflation may be sustained if it is the result of a lasting policy change, such as new taxes on foreign-made inputs, but it can also be a temporary response to an exogenous shock, such as supply chains adjusting to the re-opening of the global economy.

The second is demand-pull inflation, caused by increases in consumer demand. Demand-pull inflation can be a sign of growth if it is the result of a strong economy in which more individuals are employed, income rises, and demand rises with it. But it can also be harmful if it is triggered by new government policies that provide consumers with so much money (subsidies and transfer payments, or easy access to credit via a low cost of borrowing) that demand grows too fast for production to keep up.

The price increases facing American families today are likely the result of both types of inflationary pressures, and these pressures are interacting with each other to exacerbate prices even further. Rising consumer demand for goods is increasing consumer prices, and it is also putting pressure on businesses to increase production while they are constrained by supply chain disruptions and labor shortages. When this occurs, American families are simultaneously faced with higher prices and shortages, lowering their quality of life.

Cost-Push Inflation and Supply Chain Disruptions

Producers are experiencing significant cost increases as the United States and the rest of the world continue to grapple with COVID-related production issues. Figure 1 shows that the Producer Price Index has surged over 25 percent during the pandemic recovery, 350 percent more than the price increases after the Great Recession.[1]

Figure 1: Producer Price Index for All Commodities, 2006-2021

 

^{Source: U.S. Bureau of Labor Statistics, Producer Price Index by Commodity: All Commodities, retrieved from the Federal Reserve Bank of St. Louis}

The Producer Price Index measures the prices that U.S. producers receive for the sale of their goods and services, which is a measure of wholesale inflation. The current surge in producer prices reflects several ongoing issues tied to the COVID-era drop in production and employers’ difficulties finding willing workers, and it is exacerbated by elevated consumer demand.

First, import prices are rising. While U.S. demand for foreign made goods took a hit during the pandemic, imports have now fully recovered. In fact, imports from Asia are surging – up 33 percent over pre-pandemic levels in the first half of 2021.[2] At the same time, other countries lag the United States in their economic recoveries and supply chains are still facing disruptions. This mismatch between U.S. demand and global supply has put upward pressure on import prices, which in turn translates into higher producer prices, as 60 percent of U.S. imports are inputs to production used by American businesses.

The uneven recovery in global production is also creating shortages of raw materials like steel and lumber and essential components like semiconductor chips, and scarcity is in turn increasing costs. These trends are a residual product of the sudden global recession in 2020, which caused many factories to shut down, scale back production, or retool their production facilities to meet a different consumer need. For example, when demand for vehicles plunged during the pandemic, many semiconductor manufacturers switched from producing chips for automobiles to producing chips for consumer electronics, which remained in high demand as Americans were forced to stay home. That decision, however, combined with the widely employed “just-in-time” inventory strategy left semiconductor manufacturers ill-equipped for auto chip production when demand for autos recovered faster than anticipated.

The United States is also facing labor shortages, which is further exacerbating rising producer prices. Recent Joint Economic Committee analysis finds that in 30 states there are more jobs available than Americans looking for work. In the manufacturing industry, for example, employment has yet to recover from its pandemic lows even as manufacturers actively seek to expand their workforces. Labor shortages are harming businesses in the services industry, too, with recent surveys of non-manufacturers revealing that “stimulus checks and extension of unemployment are hampering their ability to hire workers.” Indeed, new claims for unemployment insurance remain over 50 percent above pre-pandemic levels, signifying Americans’ reluctance to return to work and a skills mismatch between unemployed Americans who are seeking work and the skills businesses demand.[3]

Finally, U.S. producers are facing higher transportation costs, driving up producer and consumer prices. In August, the cost of freight transport in the United States was nearly 35 percent higher than the year prior, representing substantial new cost pressures that show no signs of diminishing. Current labor shortages are one reason for this cost hike; goods producers simply cannot find an adequate supply of truck drivers, railroad workers, or other transportation workers to meet their needs. Another factor is the rising price of autos—as supply chain disruptions reduce the availability of new vehicles, buyers are flocking to used vehicles, causing used car and truck prices to skyrocket.

Perhaps the largest driver of rising transportation costs is the massive increase in consumer demand for goods, which has in turn increased demand for freight transport and shipping prices. The cost of shipping containers are skyrocketing—up 350 percent year-over-year in August—as companies struggle to secure enough containers for transport. Furthermore, the growing number of cargo ships transporting goods to the United States is overwhelming America’s ports and causing massive shipping delays. Reports suggest that at least 350 container ships are stuck outside of ports around the world, and that in the United States, cargo ships off the west coast are being forced to dock for seven to 10 days before space becomes available for them to offload. There is simply not enough port infrastructure to accommodate the volume of foreign-made goods that American producers and consumers are currently demanding.

That brings us to the second reason for mounting inflationary pressures: demand-pull inflation.

Demand-Pull Inflation and Government Stimulus

While the world grapples with supply chain issues, COVID stimulus measures and other federal programs have increased U.S. household income beyond what it would have been if there was never a pandemic. As discussed in the 2021 Joint Economic Report, “under the unusual circumstances of the COVID-19 pandemic, personal income was sustained through fiscal policy even as people spent less, workers lost jobs, and businesses lost revenues.” The result was unprecedented: disposable personal income rose as the economy shrank.

Figure 2 displays this rise in disposable personal income, showing that it spiked at three distinct times—in March 2020, January 2021, and March 2021—each corresponding to a different round of COVID-19 stimulus bills and economic impact payments to households. The chart also shows that, as government intervention provided U.S. households with their highest income boost on record, consumers were wary of the economic uncertainty caused by the pandemic and felt unsafe spending their money on activities requiring in-person interactions. As a result, consumer spending fell at the same time that household income rose, and Americans started saving more than they ever had before—nearly tripling aggregate U.S. savings in the second quarter of 2020.

Figure 2: Real Disposable Personal Income vs Real Personal Consumption Expenditures, 2006-2021

 

^{Source: U.S. Bureau of Economic Analysis, Real Disposable Personal Income, and U.S. Bureau of Economic Analysis, Real Personal Consumption Expenditures, both retrieved from the Federal Reserve Bank of St. Louis}

The story of increased saving and decreased consumer spending in the face of rising incomes seems to contradict the traditional view of demand-pull inflation, defined as too much money chasing too few goods (and services). In fact, personal consumption expenditures in the second quarter of 2021 were nearly identical to pre-COVID forecasts from the Congressional Budget Office.[4] Therefore, to better understand current inflationary pressures, it is helpful to break consumer spending down into spending on goods vs. services.

Figure 3: Real Personal Consumption Expenditures, Goods vs. Services, 2006-2021

 

^{Source: U.S. Bureau of Economic Analysis, Real Personal Consumption Expenditures: Goods, and U.S. Bureau of Economic Analysis, Real Personal Consumption Expenditures: Services, both retrieved from the Federal Reserve Bank of St. Louis}

Figure 3 reveals the stark difference in recent spending patterns on goods and services. Spending on services has remained higher than spending on goods because the United States is predominantly a service-oriented economy, with over 85 percent of workers employed in service-providing industries and nearly 70 percent of consumer dollars spent on services like housing and health care.[5] Yet, over a year after the recession ended, spending on services is still below pre-pandemic levels—likely reflecting ongoing anxiety related to COVID-19 and the in-person interactions that many services require.

Spending on goods fully recovered after only four months and has since spiked 15 percent above February 2020 spending levels. The rapid rise in goods spending has resulted in demand-pull inflation, with the rise in goods prices outpacing the rise in services prices.

Rising inflation expectations may impose additional demand-pull risk. Year-ahead consumer inflation expectations have jumped in recent months, from 3 percent in January to over 5 percent in August. Expectations about future price increases may push consumers to purchase more goods today, inadvertently fueling additional demand-pull inflation. Similarly, when businesses witness consumers’ inflation expectations rising, they may increase their prices to meet those expectations.  

These demand pressures do not exist in a vacuum; they are coupled with the cost-push pressures of U.S. labor shortages and ongoing supply chain issues, all of which are building on each other to create the inflation Americans are experiencing today.

Housing Prices: A Case Study

Rising housing prices provide a practical example of how inflation is straining Americans’ finances. Housing inflation has increased rapidly after the COVID recession: The most recent release of the  S&P/Case-Shiller national home price index reveals that home prices rose at a 19.7 percent annual rate in July, its fastest pace the index’s 27 year history. Zillow similarly reports that both home and rental prices saw their largest increases on record.

The Consumer Price Index, alternatively, suggests that housing inflation may finally be cooling. It provides a more timely measure of home and rent prices, which increased 0.2 percent from July to August, only half the increase that occurred in the month prior. However, a deeper look into the data reveals that the deceleration in shelter inflation is driven by falling hotel prices, a reflection of increased COVID-19 anxiety and Americans’ growing reluctance to travel. If there were no concerns about COVID-19, housing inflation would continue to accelerate.

Like most of the inflation currently being experienced, the underlying inflationary pressures driving up housing prices can be explained by a blend of demand-pull inflation, caused by increased demand for housing, and cost-push inflation, caused by materials shortages.

COVID-19 spurred demand-pull housing inflation by speeding up two pre-existing trends—rising remote work and relocation—spurring many Americans to leave urban cities for surrounding suburban areas where home ownership is more attainable. The combination of Americans moving to new areas where they can afford housing, having government-induced higher income and savings, and the Federal Reserve’s near-zero interest rates significantly increased the demand for housing.

Demand-pull inflation was exasperated by a decrease in housing supply. For instance, the supply of existing homes for sale fell 30 percent between March 2020 and March 2021, as ongoing economic uncertainty caused many homeowners to be wary of putting their homes on the market.

The supply of new homes was simultaneously hampered by cost-push inflation, which increased the cost of building new homes. The rise in construction prices was caused by labor shortages and supply chain issues that increased the cost of lumber, aluminum, steel, and other materials.

The result is a historically tight housing market with the resulting climbing home prices, a worrisome development for American families. Low-income families are disproportionately affected because they devote a higher percentage of their overall spending to housing, and the housing-share of lower-income budgets has been rising over time. In 2019, consumers in the lowest 20 percent of the income distribution dedicated nearly one fourth of their total spending to shelter (i.e. homes and rents) compared to around 18 percent among the highest-income Americans.

The good news is that housing supply may be increasing—reflected by a rise of new housing starts and in the monthly supply of houses in the United States—which would help to alleviate inflationary pressures caused by increases in demand. Yet, supply chain disruptions, labor shortages, and other cost-push pressures persist.

Will Additional Government Stimulus Increase Inflation Further?

While it is helpful to look back and understand the forces behind recent inflation, it is just as important to look forward and examine the potential implications of upcoming spending bills. Might the additional, transformative government spending currently being considered in Congress, as well as any upcoming spending bills that have yet to be introduced, increase inflation even further? The answer is, very likely, yes.

The largest spending measure currently being debated is a $3.5 trillion spending package, also known as “the reconciliation bill.” The reconciliation bill uses a combination of deficit spending and tax increases to expand social programs. Some of its most notable provisions would provide free universal pre-kindergarten education, extend the recent expansion of child tax credits, subsidize day care centers, health insurance, and housing, provide free paid family and medical leave, and provide two years of free community college. It also includes a slew of new tax increases on personal income, corporate income, and investment income.

The economic implications of this legislation say nothing about its aims; increasing affordability for American families is a worthwhile goal. However, by providing households with more cash (either directly with checks or indirectly with subsidies), the practical impact will be to further increase consumer demand. Additionally, the tax provisions of legislation will likely reduce business investment and hiring. These two forces combined will create more demand-pull inflation.

For example, the expanded child tax credit currently provides the vast majority of American parents between $3,000 and $3,600 of cash transfers per child per year. Without the work requirements that were previously attached to the child tax credit incentivizing parents to find employment, these cash transfers do nothing to increase labor force participation and may even decrease labor supply, which remains below its pre-pandemic level. Other subsidies included in the reconciliation bill operate similarly, expanding household incomes and inflating demand, and paid for with tax increases that will depress employment and investment.

Although the reconciliation bill would likely increase inflationary pressures, there are a few reasons why inflation may not materialize. The first is if increases in consumer demand are successful in pulling enough people into the labor force, in which case inflation may not accelerate further. However, with the resurgence of COVID-19 and continued supply-chain disruptions that are likely to take months or years to return to normal, it is unlikely that artificially increasing incomes would result in significant demand-driven job creation. Furthermore, the tax provisions in the bill will likely reduce hiring and discourage business investment.

The second reason inflation may not materialize is if spending does not rise with income, perhaps due to rising consumer anxiety around COVID-19. However, if the past is any indication, spending on services would fall and spending on goods would continue to climb, in which case supply chain bottlenecks would continue to increase producer prices and inflation would result.

The finally, some argue the reconciliation bill will increase employment and production enough to offset the increase in consumer demand. These supply-side provisions would, for example, provide more money for federal job training programs and establish a new “civilian climate corps.” Yet, these measures are unlikely to have a significant impact on labor force participation and will not be enough to counteract the employment and investment-reducing effects of tax increases. Prior research demonstrates that existing federal job training programs are largely ineffective and not responsive to current and future labor force needs, and estimates suggest that a civilian climate corps may produce at most 20,000 government jobs—a drop in the bucket compared to the 11 million job openings that U.S. businesses are currently struggling to fill.

While the new programs as enacted would be temporary, there is a (very good) chance that Congress would eventually make them permanent. In that case, estimates suggest that the legislation would actually trigger $5 to $5.5 trillion of government spending over the next ten years and add $3.5 trillion to the national debt. Federal debt is already at 100 percent of GDP, and rapidly increasing the size of the debt without generating a significant increase in economic growth carries its own set of risks. These risks include reduced economic output, higher interest payments, lower national income, rapid inflation, and even a debt crisis.

Conclusion

Rising prices are harming American families by reducing their real earnings and undercutting their purchasing power during the post-COVID economic expansion. Debate exists over whether this inflation is a natural product of our unique times or driven by government policy, however the evidence suggests it is a mix of both.

The reopening of the economy after global COVID-19 shutdowns has generated temporary inflation in key consumer goods; producers are experiencing both shortages and rising costs for intermediate inputs, raw materials, and labor, which they are in turn passing on to consumers. While this type of inflation is transitory, it will likely persist until labor shortages diminish and global supply chains readjust.

Compounding the pressures of constrained supply, increases in household income from government stimulus measures may have ignited more lasting demand-driven inflation. If Congress continues to enact new government spending that further increases consumer demand while supply remains constrained, inflation could become worse. The American people would be better served by policies geared toward returning Americans to work and removing barriers to business investment in American workers.

Federal Reserve Chairman Jerome Powell recently acknowledged these inflationary risks, indicating that the Federal Reserve may soon begin reducing its asset purchases to counteract rising prices. Unfortunately, if extraordinary spending levels continue, monetary tapering or even tightening may not have its intended effect. Congress should therefore consider the inflationary risks of continuing its recent pattern of ballooning government spending.

Jackie Benson
Senior Economist