While the war in Ukraine has harmed the global economy and is a humanitarian disaster, inflationary pressures had been building for months prior to Russia’s invasion. Broader supply chain disruptions have also been a challenge; however, even with high inflation, we are seeing signs that these issues are easing. Inflation is primarily caused by U.S. Federal Reserve (Fed) policies that have been too loose for too long and continue to be overly accommodative in our opinion.
The primary source of inflation is the massive amount of fiscal stimulus that has been augmented rather than offset by loose Fed policy.
The American Rescue Plan Act, passed in March 2021, was far larger and more cumbersome than necessary. Passing a $1.9 trillion stimulus package after the US economy had already begun to improve was both unnecessary and foolish.
At the time, unemployment was low and job openings were plentiful, making the need for such a large package questionable. Coincidentally, the number of open jobs in the United States surpassed the number of unemployed people looking for full-time work in March 2021. In March 2022, there were approximately 4.8 million unemployed Americans looking for full-time work, with 11.5 million job openings.
Automobile production in the United States has recovered to its highest level in more than a year, while used car prices are no longer contributing to the inflationary environment.
Former U.S. Treasury Secretary Larry Summers suggested at the time that the American Rescue Plan Act legislation included fiscal spending at roughly three times the estimated gap between economic potential and actual size of the U.S. economy (Easley, 2021).
The difference between the actual size of the economy and the Congressional Budget Office’s estimate of economic potential shrank from more than $2 trillion in the second quarter of 2020 at the height of the crisis to just over $600 billion in the first quarter of 2021, when the $1.9 trillion legislation was enacted.
Providing so much fiscal stimulus at a time when the gap between actual and potential output is rapidly closing would increase inflationary pressures.
As Summers pointed out, the likely inflationary risks from the legislation could be mitigated if the Fed responded quickly with tighter monetary policy, government spending cuts, and higher taxes.
Clearly, none of this occurred, and as Summers correctly predicted, the result is high inflation.
Because inflation is typically caused by too much money chasing too few goods, and monetary policy is the Fed’s responsibility, the Fed is ultimately to blame for our breakout inflation.
The Fed’s assistance during the liquidity shock was both necessary and prudent, as were the initial rounds of fiscal support. Rather than continuing to pump money into the economy through bond purchases for another year following the $1.9 trillion fiscal expansion,
To offset the inflationary impulse of trillions of dollars chasing too few goods, the Fed should have raised rates and tightened quantitative policy. In fact, prior to March 2021, inflationary pressures were already rising.
In 2021, a year before Putin and Russia invaded Ukraine, inflation was on the rise.
As only the Fed controls the money supply, the current price inflation was ultimately caused by a failure of US Federal Reserve policy.
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