Understanding inflation in the US

The inflation rate in the US touched 8.6 per cent in May. This is more than four times the 2 per cent target rate and at a 40-year high. In order to understand the present, we need to first consider the past. 

During the Great Depression of the 1930s, real per capita gross national product fell by one third in the US. Also, there was 25 per cent negative inflation, and a massive shift from bank deposits to currency. Over one-third of the banks failed. In 1936, John Maynard Keynes gave legitimacy to additional public spending through large fiscal deficits in a recession, and rightly so. This was to take care of output and employment. Subsequently, by 1963, Milton Friedman had given clear legitimacy to a huge increase in central bank money during a crisis. Again, rightly so. This was to prevent systemic banking failures and negative inflation. 

The work of both Keynes and Friedman, though very different, was extremely useful in dealing ex-post with the global financial crisis and the Great Recession in and around the year 2007 (the ex-ante story is very different). The US governent came out with a large fiscal stimulus. The Fed intervention too was massive. 

From 2008-09 to 2014-15, the central bank money was increased in the US by about $3 trillion. However, that was mainly used as a store of value by financial institutions for whom it was difficult to expand credit, given factors like the slow recovery and the additional financial regulations. Though the rise in the central bank money was about 400 per cent, it was not so huge relative to the size of the store of value that financial institutions actually needed. Bank credit was stuck at about $9 trillion from 2009 to 2012 and even thereafter grew slowly. The bottom line is that the jump in central bank money did not translate into any jump in money in circulation with the public. This helped in maintaining low and stable inflation. So far so good. 

Fast forward to the Covid-19 crisis and the economic situation in 2020. The policymakers overextended the message from both Keynes and Friedman — more so, when they saw the absence of high inflation from 2007 to 2020. Of course, there was a need to help many people but that could have been achieved even through a reasonably sized stimulus. But the fiscal stimulus to aggregate demand was excessive and even misapplied to an extent, given the supply disruptions this time in one way or another due to the health crisis. The fiscal deficit went beyond $3 trillion in 2020; it was less than $1.5 trillion in 2009. 

Given that the new fiscal stimulus was excessive, the Fed also ended up going beyond what was optimal. This time, even the money in circulation with the public jumped; M2, a measure of such money, went from about $15.5 trillion to a whopping figure of nearly $22 trillion by May 2022. Consequently, we have had high demand-pull inflation, given the “limited” capacity to produce in the economy. 

The massive demand for final goods and services, in turn, led to higher demand for inputs like oil and various other commodities. So, their prices rose substantially. Thus, the related and the so-called cost-push inflation was endogenous. It was a consequence of the excessive stimulus. Clearly, this story is very different from the usual view that we have two separate kinds of inflation — demand-pull and cost-push. 

Next, leaving aside the cause of the so-called cost-push inflation, this latter kind of inflation cannot continue on its own. It is sustainable only if the Fed accommodates it by increasing the central bank money. The Fed did so. So, it was again in the picture.

Much had gone wrong already in 2020 and 2021. It so happened that this year Russia invaded Ukraine on February 24, geopolitical tensions rose, and China introduced restrictions in March. These factors aggravated the situation; they were not the primary causes of the high inflation. The price of crude oil had already touched about $95 per barrel by mid-February. 

Finally, although electoral concerns played a role with both the Trump administration and the Biden administration in a variety of ways, the zeitgeist by then had paved the way for the policies that came to be used. It is only in the last two months or so that economic thinking seems to be changing widely and decisively.

To conclude, lessons from economics and history need to be applied appropriately by the public authorities to the changing situations. There are hardly any neat formulae.  

The writer is visiting faculty at Indian Statistical Institute, Delhi Centre. This column is based on his address at the PHD Chamber of Commerce and Industry on 9 June 2022.  gurbachan.arti@gmail.com