Those errors began with increasing government spending to finance the Vietnam War, without the tax revenue to pay for it. They continued in 1971, when Fed Chair Arthur Burns and President Richard Nixon responded to rising inflation with a combination of rapid monetary stimulus and doomed wage and price controls. An overheating economy blew the lid off the boiling pot a few years later, and inflation shot above 12%.
True, the Fed was overly optimistic in its forecasts for inflation this year, expecting price increases to be smaller and more transitory. Larry Summers and Olivier Blanchard got it right back in February, when they correctly predicted that rapid growth would lead to inflation.
But although the Fed’s inflation forecasts were wide of the mark, its actions have arguably not been far off-target. True, the Fed did not expect to start tapering its monthly asset purchases – so-called quantitative easing – as early as November 2021. But it responded appropriately to the incoming data on inflation, as well as on the strength of the economy, by adjusting the timing of its plans.
Moreover, markets barely reacted to the November 3 taper announcement, indicating that the (now-reappointed) Fed Chair Jerome Powell had successfully communicated the central bank’s rethinking – in contrast to 1994 and 2013, when investors failed to anticipate the start of tightening cycles. If the Fed starts raising short-term interest rates in mid-2022, that will not catch markets by surprise, either.
President Joe Biden can do relatively little to stem the highly unpopular rise in inflation. He has already intervened to help unclog ports and other supply-chain logistics. Increased vaccination against COVID-19 would boost the supply of labor, for example by keeping children in school, though it is difficult to see what more Biden could do here.
A good way to moderate inflation would be to allow more imports. Former President Donald Trump’s tariffs on many products – including aluminum and steel, and almost all US imports from China – raised prices for consumers. Biden should be able to persuade China and other countries to lower some trade barriers against the US in exchange for removing US tariffs. In any case, trade liberalization could reduce some prices quickly.
Some argue that the new government expenditure envisaged in Biden’s social spending bill would work to raise inflation, either because they disapprove of big government or because a dollar of spending raises demand more than a dollar of tax revenue reduces it. Others think the net effect on inflation will be beneficial (particularly in the longer run), because many of the planned programs, such as universal quality preschool, will increase labor supply.
Regardless of these arguments, the new legislation’s effect on inflation should be minor. Biden’s infrastructure package and proposed social spending should be judged on their own merits. Rising US inflation reflects the economy’s rapid recovery from the COVID-19 recession, which means we should get our heads out of the 1970s.
Jeffrey Frankel, professor of capital formation and growth at Harvard University, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He is a research associate at the U.S. National Bureau of Economic Research.