NEW YORK—After several years of debate over what has led to the spike in inflation—government stimulus or pandemic-related issues--two top researchers have weighed in on the issue.
According to the researchers, the answer is both economists are correct.
“Pandemic-related supply shocks explain why inflation shot up in 2021, while an economy overheated by fiscal stimulus and low interest rates explain why it has stayed high ever since,” according to the study released by Ben Bernanke, former chair of the Federal Reserve, and Olivier Blanchard, former chief economist of the International Monetary Fund.
Bernanke is now at the Brookings Institution and Blanchard is at the Peterson Institute for International Economics.
Role of Rescue Plan
“When Congress passed President Biden’s $1.9 trillion American Rescue Plan in early 2021, which included checks to households, enhanced jobless benefits and aid to state and local governments, inflation was around 2% and unemployment, though coming down, still above 6%,” noted the Wall Street Journal in its coverage of the new report. “At the time many forecasters thought the stimulus could push demand above the economy’s potential to supply goods and services and unemployment below its long-run natural rate of around 4%. Yet few thought this would meaningfully raise inflation.”
The Journal analysis of the new report noted that in previous decades unemployment had remained similarly low without raising price pressures.
A Warning
“A few disagreed, notably former Treasury Secretary Lawrence Summers and Blanchard. Both warned the stimulus was so large it would push the economy dangerously into overheating territory,” the Journal stated.
Inflation did shoot up, as they feared.
“The critics’ forecasts of higher inflation would prove to be correct—indeed, even too optimistic—but, in substantial part, the sources of the inflation would prove to be different from those they warned about,” Blanchard, one of those critics, and Bernanke write in their study, the Journal said.
Building the Model
According to the report, to tease out the sources of inflation, Bernanke and Blanchard build a relatively conventional model in which inflation is a function of, among other things, the gap between the supply and demand for labor, the public’s expectations of inflation, and commodity prices. They include a variable for supply-chain disruptions derived from Google searches for “shortage,” the Journal added.
“Usually economists judge labor market tightness from how far unemployment is above or below its natural rate,” the Journal continued. “But this time the labor market heated up before unemployment got that low. So instead, Bernanke and Blanchard use the ratio of job vacancies to unemployed workers. Finally, their model lets all these factors interact, with varying lags.”
Additional Notes
The research further notes:
- If stimulus had overheated the economy, it should have shown up in the labor market, i.e., an unusually high ratio of vacancies to unemployed. “In fact, labor market conditions put downward pressure on inflation through the third quarter of 2021,” the authors concluded. “Instead, the inflation that year was driven almost entirely by shortages and energy prices.”
- Demand shifted abruptly from services to goods in the early months of the pandemic. “The overall effect should have been a wash as prices rose for goods and fell for services. It wasn’t, because goods producers faced supply constraints, which caused costs and prices to spike, while costs to service producers didn’t decline much.”
Why Didn’t Inflation Fall?
The analysis noted the pandemic disruptions did eventually subside.
“Why didn’t inflation then fall? The reason, the authors conclude, is that by this point demand was so strong, reflecting the legacy of low interest rates and fiscal largess, the labor market was significantly overheated with the ratio of vacancies to unemployed up dramatically,” the Journal said.
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