President Joe Biden’s $1.9 trillion economic relief plan is on the verge of becoming law. With so much uncertainty about the likely course of output, employment and prices, its effect on the economy is unusually hard to predict. But it’s a fact that Congress is providing much more stimulus than any reasonable dollar estimate of the economy’s underlying need.
That’s provoked a debate among policymakers and economists about the risk of sustained, runaway inflation, with warnings of the dangers posed by widening deficits countered by assurances that the government possesses the tools to keep prices and wages under control.
But there’s a third possibility, a gloomy scenario that deserves more attention than it’s received: the likelihood that this experiment in spending so much more than the economy needs will end in a mild recession caused by a backlash at the Federal Reserve. That outcome could deny low-wage workers the benefits of a longer economic expansion.
Even without the additional $1.9 trillion, the economy in 2021 was poised for a strong increase in consumer demand for goods and services. Congress passed a $900 billion stimulus in December that will support the economy this year. (That law by itself is larger than the stimulus Congress passed in the waning days of the 2009 recession provoked by the global financial crisis.)
Households are sitting on $1.8 trillion of excess savings, and will spend a large share of that over the course of this year. The pandemic is fading, states are reopening, and households are surely going to go a little wild this summer and fall.
Add Biden’s $1.9 trillion — much of which will go into consumers’ pockets — and demand will surge.
This additional stimulus is certain to push the economy above its sustainable level of output. By my calculations, without the president’s plan, the pandemic would reduce economic output by $330 billion over the remainder of 2021. So even if the stimulus only generates 50 cents of economic activity for every dollar of government spending, it would still fill that hole nearly three times over.
The combination of this extraordinary amount of fiscal support and unusual macroeconomic environment is likely to cause three things to happen.
First, surging demand in the face of lagging supply will put upward pressure on the underlying pace of consumer price increases. Markets currently expect inflation to average 2.4% over the next five years, up from around 1.5% prior to the pandemic and 1.6% prior to the presidential election in November.
If investors are right, then inflation will hit the sweet spot — higher than the Fed’s 2% target, but not so much higher as to cause concern. Trend inflation of 2.5%–3% would be a policy victory.
Second, there will be a month here and a month there where inflation will deviate from its underlying trend, with aberrant, transitory monthly price level increases of, say, 4% or 5%.
Periodic bursts of eye-popping price growth may not be sustained, or even problematic, but the second or third time one occurs, it will receive a lot of attention. Inflation will be front-page news. Republican members of the Senate and House of Representatives will demand hearings and grill policymakers. It will be the talk of Wall Street.
Third, the president’s stimulus law will fuel concern about bubbles in financial markets. Personal income will soar once the new stimulus is enacted. A lot of that money will be saved. And much of those savings will go into assets like stocks and real estate, pushing up their prices. Indeed, due to the extraordinary fiscal support already offered to households by Congress, the past year has seen months with record rates of personal income growth and savings.
These three factors — an above-target underlying rate of inflation, periodic bursts of rapid price growth and concern about bubbles — add up to a bad situation for the Fed, which would be put on the defensive about its blasé attitude toward overheating. Fed governors could wake up one day feeling that they had fallen behind the curve.
Knowing that monetary policy affects the economy with a lag — and being able to declare victory in having allowed inflation to rise above its target rate — the Fed could attempt to slow the expansion without ending it. But the Fed can’t manage the economy with precision. In this scenario, the Fed would probably cause a mild recession.
This could leave low-wage workers out of the recovery. A rising tide does lift all boats, but not at the same pace or at the same time.
Take the expansion following the recession that ended in 2009. My research with economist Jay C. Shambaugh shows that wages for the bottom 20% of workers were much higher when the pandemic began in 2020 than when the financial crisis struck in 2007.
But we found that wages for those workers didn’t begin to rise until 2014. If that expansion had ended in 2014, after five years, then most workers would have been in worse shape following the expansion than when the recession began in 2007.
This highlights the importance of keeping expansions going as long as possible. A hot economy with tight labor markets is the best jobs and wages policy. But the likelihood of a backlash to a too-hot economy and frothy financial markets puts the longevity of the current expansion at risk, along with its benefits for workers near the bottom of the wage scale.
An even worse outcome is possible, and has received a lot of attention. Demand could surge even more than I expect. The generosity of unemployment benefits could keep many workers on the sidelines, holding back the ability of economic supply to meet demand.
In addition, Congress and the White House are already talking about spending trillions more this year on climate, infrastructure and health care, apparently unconcerned about the effects of more deficit spending. Combine that with the Fed’s surprising lack of concern about inflation, and markets and households could quickly come to expect higher inflation in the future. Once inflation expectations diverge from the Fed’s target rate, the Fed would have to deal the economy a hard blow to reset them.
Or everything could work out just fine. I noted last week that the US is in a moment of truly unusual economic uncertainty, and I could be wrong about quite a bit. Inflation expectations could stay as low as the Fed’s target. Surging demand could lead to a large increase in imports, easing the pressure on the domestic economy and leading to less overheating. Households could remain wary of the virus and reticent about resuming normal levels of activity, leading to a smaller demand surge.
Supply would then be better able to keep up. Rising interest rates could reduce equity and house prices, tamping down concerns about financial market bubbles.
This happy ending is certainly possible. But given the importance of long expansions, it is reckless of the president to bet on it.