What Another $3.5 Trillion Could Do to Inflation

With inflation at its highest level in several decades, centrist Democrats are beginning to echo Republican concerns that the Democrats’ $3.5 trillion spending package will further overheat a U.S. economy already struggling to keep up with demand. Those worries are justified — but critics shouldn’t get ahead of themselves.

Inflation will almost certainly drift downward in the near term even if the full package is passed into law, which is unlikely. The real concern is that the package would exacerbate more fundamental supply constraints in the economy, driving up inflation over the longer term.

To see clearly what’s going on, it’s necessary to separate the inflationary pressures into three parts: increases in overall spending in both the public and private sectors; supply-chain disruptions directly related to Covid; and a puzzling weakness in the the job market.

The best way to view the first is to look at nominal GDP, a measure of total spending in the economy without correcting for price changes. Slowdowns in NGDP growth are a hallmark of demand-driven recessions, and recoveries from those recessions tend to be weak until NGDP returns to its pre-recession path.

The collapse of NGDP in the spring and summer of 2020 was historic, dwarfing what was seen after during the Great Recession. Yet, because of the enormous relief packages passed by Congress and the unconventional interventions of the Federal Reserve, the rebound in NGDP has been equally unprecedented.

Increases in public and private spending over the last year have been just enough to get the economy back on track without generating excess inflation. Under normal circumstances, this would be a Goldilocks economy: not too cold, not too hot.

Circumstances, however, are far from normal. The pandemic has generated supply-chain disruptions — particularly in the auto industry, construction materials, food and energy — that are driving prices higher and sapping spending power from the rest of the economy. Used-car prices rose a staggering 41.7% over the last 12 months, almost exactly matching the 41.8% increase in the cost of gasoline.

Instead of a Goldilocks economy, the U.S. is risking stagflation: rising prices combined with sluggish job growth. It’s understandable, then, that both Republicans and centrist Democrats are wary of even more spending.

They can take some solace in the likelihood that these extreme price increases are likely not only to slow but also to reverse themselves in the coming months. Lumber costs for construction companies soared 125% between April 2020 and July 2021. But they were already falling in June, the last month for which data is available, and will inevitably fall further given the sharp decline in futures prices since May.

The less comforting facts come from the service sectors and housing. Restaurants, hotels and other recreation services are seeing high prices despite the fact that demand for those services is still muted because of Covid.

Wages are rising in those industries as well. It’s tempting to say these increases are also a transitory effect of the pandemic. Fear of Covid, lack of child care and the lingering effects of unemployment insurance bonuses are undoubtedly making it harder for employers to fill positons.

Wage increases, however, are extremely difficult to roll back — and so employers tend to be reluctant to offer them in response to a temporary shortage. So rising wages is an indication that few businesses are expecting a surge in job applicants once schools reopen and unemployment bonuses run out.

As for housing, existing home prices are rising at a record pace. Perhaps that’s simply due to newly remote workers trading in their cramped city apartments for more space in the suburbs or beyond. Even if so, such increases would typically lead to a boom in new-home construction that would provide jobs and increase the housing stock.

Yet after a sharp jump in June, new home sales have steadily fallen. That suggests a more profound mismatch between supply and demand that can’t be explained by lumber prices alone. If the imbalance persists, it could lead to steadily rising values of “owner’s equivalent rent,” a key component of inflation.

Put all this data together, and it’s plausible that the failure of the job market to recover — there are still about 7 million fewer jobs than there were before Covid — isn’t due to a lack of overall spending. It’s due to supply constraints; the spending is leading to higher prices instead of more jobs.

Some of the more extreme constraints will ease on their own, bringing down the overall rate of inflation. But more fundamental constraints seem likely to persist. It’s these constraints that President Joe Biden and Democrats should be worried about as they continue their efforts to add even more spending to the economy.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a Bloomberg Opinion columnist. He was formerly vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina. He is also co-founder of the economics blog Modeled Behavior.

©2021 Bloomberg L.P.

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