fbpx Facing down a surprising U.S. inflation surge | Harvard Kennedy School

Inflation in the United States has jumped to the highest level in 30 years, reaching 6.2% in October as measured by the Consumer Price Index. The COVID-19 pandemic has fueled consumer demand for goods and services at a time when supply lines are constrained and many industries have been affected by staff shortages. The inflation surge has generated intense political debate on the causes and the appropriate response.

We asked several economists and public finance experts at Harvard Kennedy School—all of whom have held senior federal government economics roles—to offer brief perspectives on how they view the underlying issues and the key policy choices facing the Biden administration and Congress. 

 

Inflation risks also lie ahead for state and local governments

Linda Bilmes headshot.The impact of inflation on subnational governments varies depending on how the local jurisdiction raises its own-source revenues and how well it can control spending.

On the revenue side, income and sales tax receipts will largely keep pace with inflation, so moderate inflation is unlikely to have a major impact. However, if inflation leads to sharply higher interest rates that lead to a stock market sell-off, then states that are highly dependent on capital gains taxes (such as California and New Jersey) may suffer. Another area of vulnerability could be property taxes, especially states where increases in assessed values or in property taxes are capped, as with California’s Prop. 13. These prevent rising house prices feeding through into state revenues, and are also the major revenue source for local governments.

On the expense side, the biggest risk is rising wages, which consume the largest share of state budgets. We could see public sector unions pushing for a return of “CPI-plus” language in new labor agreements. This would automatically bake in the cost of higher inflation to local expenditures. In addition, high inflation could significantly weaken state pension plans, many of which assume that future wage increases will be only 2%.  Most of the current generation of local pension managers have little experience with inflation. They need to begin adjusting their portfolios now to prevent erosion of their asset bases.

Linda Bilmes is the Daniel Patrick Moynihan Lecturer in Public Policy and previously served as Assistant Secretary of Commerce.

What's certain is just how many uncertainties lie ahead

Karen Dynan headshot.As policymakers gauge the appropriate response to rising inflation, a key challenge is uncertainty about what the future holds. We know that many factors have contributed to the recent increase in inflation. Underlying demand, which is strong, has shifted towards certain types of goods, with ongoing fears of the virus continuing to suppress interest in high-contact services. But bottlenecks and supply chain problems have inhibited the ability of producers to respond to the shift. In addition, energy prices are up sharply, and shortages of workers are leading to higher wage growth in some sectors.

What is not clear is how quickly these issues will resolve. The size and persistence of demand/supply imbalances has repeatedly surprised us, in part because virus caseloads have stayed unexpectedly high. We have only a limited understanding of why so many would-be workers are staying out of the labor force, making it hard to predict how many will return and how quickly. We are not sure how much inflation expectations have risen (a critical determinant of whether higher inflation sticks) because of measurement difficulties.

This uncertainty makes it difficult for monetary policymakers to know when they need to begin raising rates to avoid letting inflation stay at undesirably high levels. Given that they may need to revise their views quickly based on incoming data, it is especially important that they communicate the high degree of uncertainty. Surprising financial markets with an abrupt unexpected change in policy could lead to a rapid decline in asset prices that causes a significant setback in the economic recovery.

Karen Dynan is a professor of the practice of economics and former chief economist of the U.S. Treasury.

 A gas pump showing gas prices close to five dollars per gallon, with the words "Same Low Price, Cash or Credit"

Some inflation-fighting do's and don'ts

Jeffrey Frankel headshot.What can President Biden do about the return of 5% to 6% inflation?

Let’s start with two don'ts.

  • Don’t do what Federal Reserve Chair Arthur Burns and President Richard Nixon did in 1971, in order to help the president’s reelection: They responded to moderate 5% to 6 % inflation with a combination of rapid monetary stimulus and doomed wage-price controls. The lid was blown off the boiling pot a few years later; the inflation rate jumped above 12%.
  • Don’t do what Donald Trump did on April 2, 2020, to help out American oil producers: He persuaded Saudi Arabia that OPEC must cut oil output and raise prices.


Four do’s:

  • Continue to fight in the Senate for a fully funded social spending bill (“Build Back Better”).
  • Let imports into the country more easily.  They are a safety valve for an overheated economy.  Trump put up a lot of import tariffs, which raise prices to consumers—sometimes directly, as with washing machines, and sometimes indirectly, as with steel and aluminum, which are important inputs into autos and countless other goods. With or without foreign reciprocation, U.S. trade liberalization could bring prices down quickly in many supply-constrained sectors. 
  • Similarly, facilitating orderly immigration would help alleviate the shortage of workers that employers in some sectors are experiencing.
  • Further vaccination would increase the supply of labor, through several possible channels.  One channel would be to keep children in school, allowing more parents to go back to work. Another channel is to alleviate worker’s fears of infection in the workplace. 

Jeffrey Frankel is the James W. Harpel Professor of Capital Formation and Growth and was a member of the Council of Economic Advisors from 1983-1984 and 1996-1999.  

Supply and demand—and the Federal Reserve’s key role

Jason Furman headshot.The United States economy has grown much faster than most people, including myself, would have expected. The flip side of this growth has been the highest inflation we have experienced in 30 years. We should be humble about our ability to project what will happen over the next year given how terrible the forecasts were for this past year. But it is reasonable to assume that even if some of the sources of the inflation are temporary and go away there is still enough support for uncomfortably high inflation.

Economists like to explain everything with demand and supply, and the concepts work well here. Demand is likely to remain high, fueled by households with healthy balance sheets, continued fiscal support, and very low interest rates. No one knows how long it will take supply to recover, or even whether it will fully recover, but it could be at least a year. The combination of strong demand and weak supply will likely keep inflation uncomfortably high.

President Biden can do a little about inflation by helping with port capacity and other supply-chain measures. Even better would be dropping President Trump’s tariffs on China. But these steps would only be small. The main agency charged with controlling inflation is the Federal Reserve. They are right to continue to be focused on the millions of people without jobs but should recalibrate towards incorporating more concern for inflation into their policy stance, including setting a default of more rate increases in 2022, something it can call off if inflation and/or employment is well below what we are currently expecting.

Jason Furman is the Aetna Professor of the Practice of Economic Policy and previously was chair of the Council of Economic Advisors under President Obama.

Biden team needs to signal its determination to address inflation

Larry Summers headshot.I was pleased to see Federal Reserve Chair Powell’s comments that the Fed would “consider wrapping up the taper of our asset purchases, perhaps a few months sooner.” I have long advocated that given the house-price boom, mortgage-related purchases should stop immediately. Because of inflation, real interest rates are lower, as money is easier than a year ago. This is a good sign.

 Simultaneously, the Administration should signal that a concern about inflation will inform its policies generally. Measures already taken to reduce port bottlenecks may have limited effect but are a clear positive step. Buying inexpensively should take priority over buying American. Tariff reduction is the most important supply-side policy the administration could undertake to combat inflation. Raising fossil fuel supplies, such as the recent deployment of the Strategic Petroleum Reserve, is crucial. And financial regulators need to step up and be attentive to the pockets of speculative excess that are increasingly evident in financial markets.

 Excessive inflation and a sense that it was not being controlled helped elect Richard Nixon and Ronald Reagan, and risks bringing Donald Trump back to power. While an overheating economy is a relatively good problem to have compared to a pandemic or a financial crisis, it will metastasize and threaten prosperity and public trust unless clearly acknowledged and addressed.

Lawrence H. Summers is Charles W. Eliot University Professor , Weil Director of the Mossavar-Rahmani Center for Business and Government, and president emeritus of Harvard University. His government positions included Secretary of the Treasury in the Clinton Administration and Director of the National Economic Council under President Obama. Portions of this essay were excerpted from a Washington Post column.

Banner image by AP Photo/Noah Berger; inline image by Xinhua via Getty Images; faculty portraits by Martha Stewart

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