January 16, 2022

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Betting on transitory US inflation is still valid

The writer is a senior fellow at Harvard Kennedy School

As 2021 ended, Team Transitory was in retreat in the US. The rapidly accelerating inflation predicted by economists including former Treasury secretary Lawrence Summers and former IMF chief economist Olivier Blanchard had appeared. Consumer prices rose 6.8 per cent in the year to December, the fastest increase since 1982. By their December 15 meeting, even the Federal Reserve policymakers who had counselled patience were worried. Minutes of the meeting, released this week, reveal discussions about raising interest rates and shrinking their balance sheet faster than markets had anticipated.

I would caution them not to abandon their position so easily. After trillions of dollars spent on fiscal support, too much money may have been chasing too few goods by the end of last year. But this year I think the situation will reverse, with growth and inflation slowing. According to the Brookings Institution’s Fiscal Impact Measure, local, state and federal tax and spending policy added over 7.5 percentage points to US gross domestic product growth in the first quarter of 2021. But the fiscal impulse turned negative thereafter — and it is expected to be a drag on the economy through at least the third quarter of 2023. These forecasts include the new infrastructure spending plan.

And even if parts of the stalled $1.75tn Build Back Better stimulus are passed this year, actual government spending in 2022 would remain small, and partially offset by ramped up tax collection. According to the Office of Management and Budget, the swing in the budget balance in 2022 from a year ago will be nearly nine percentage points, the second largest retrenchment since records began in 1930. Some argue this fiscal cliff is simply the government handing the baton for generating demand to consumers. Stimulus checks, beefed up unemployment insurance and expanded child tax credits boosted personal savings by over $2tn, so the higher consumption that affords can offset the fiscal drag.

While the overall stock of savings is astounding, it is dwindling, and it was not distributed evenly in the first place. The personal savings rate has reverted to pre-pandemic levels of around 7 per cent. According to the JPMorgan Chase Institute, low-income families saw the highest percentage gains in savings from fiscal measures, but exhausted their savings faster. For low earners, the proportion of any income increase that is spent on consumption is typically higher than among the wealthy. The government can’t hand a baton to people who have burned through their savings. According to Moody’s Analytics, excess savings among working- and middle-class households could be exhausted early this year. And high-income consumers who don’t spend all their savings are little help.

The upshot is likely weaker inflation. Unemployed respondents to a survey by Indeed.com said their financial cushion was one of the top three reasons for not urgently seeking a job. As those savings run down, many who dropped out of the labour force will try to return, boosting labour supply and easing upward pressure on wages, and therefore prices.

What about business investment? Even limited Fed rate hikes will increase borrowing costs in 2022. Ten-year US Treasury yields are rising, and it’s hard to argue the investment environment will improve in 2022. The dollar will strengthen, pushing down inflation and exports.

Foreign demand may also be weak. Chinese growth slowed precipitously in the second half of 2021, partly in pursuit of financial stability. While Beijing has signalled it will do more to support growth in 2022, long-term issues persist. Cascading property sector defaults are a key risk, as is China’s zero-Covid policy, which is prompting new factory closures and lockdowns.

These may exacerbate existing global supply-chain disruptions in early 2022. But there are other indications that supply pressures are easing. Order backlogs and supply delivery times have improved in recent months. According to the New York Fed’s new Global Supply Chains Pressure Index, supply-chain issues “have peaked and might start to moderate somewhat going forward”. That, too, will lead to US inflation abating later this year.

The Fed may move faster and farther than anticipated early in 2022 to retain credibility as an inflation fighter. But fiscal drag, shrinking savings and weak foreign demand are likely to ease an overheated economy. This, and improving supply chains, will reduce inflation pressures. Summers and others were right in 2021, but I see the balance tipping within six months. I’m signing up for another year as a member of Team Transitory.

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