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Central bankers and most economists failed to anticipate the sharp increase in inflation that began in 2021, and public policymakers were slow to respond after insisting that price pressures were “temporary,” a new paper co-authored by former Federal Reserve Chair Ben Bernanke states.
The Fed misjudged the economic effects of pandemic-era fiscal programs, which explains why many failed to accurately forecast the inflation that resulted from the stimulus and relief measures, including the March 2020 $2.2 trillion CARES Act, the December 2020 package that consisted of $900 billion in COVID-related spending, and the March 2021 $1.9 trillion American Rescue Plan.
The CARES Act, signed by former President Donald Trump, was sufficient enough to strengthen businesses’ and households’ balance sheets and support their ability to spend in the future, the paper claims.
“Overall, as a share of GDP, the headline costs of these three COVID-era fiscal packages were about 4-1/2 times the size of the American Recovery and Reinvestment Act (ARRA), enacted in response to the 2008 financial crisis and the ensuing recession,” Bernanke and economist Olivier Blanchard wrote in the academic paper, titled “What Caused the U.S. Pandemic-Era Inflation?”
However, looking back at the coronavirus pandemic, Bernanke and Blanchard asserted that the inflation bursts were driven by several shocks, such as the dramatic rise in commodity prices, demand shifts (from services to goods), and labor tightness.
But while the economists concede that wage growth had little effect on inflation in early 2021, the paper purports that labor costs increased over time and have become more entrenched in current inflationary pressures.
“The effects of tight labor markets have begun to cumulate,” the paper noted, adding that they will likely “grow and will not subside on its own.”
“The portion of inflation which traces its origin to overheating of labor markets can only be reversed by policy actions that bring labor demand and supply into better balance,” they wrote.
As a result, the Fed has more work to do to curb inflation.
“Labor market balance should ultimately be the primary concern for central banks attempting to maintain price stability,” the paper said.
Bernanke now serves as a distinguished senior fellow at the Brookings Institution. Blanchard, who previously worked as the director of the International Monetary Fund’s research department, is a senior fellow at the Peterson Institute for International Economics (PIIE).
In January 2021, the consumer price index (CPI) was 1.4 percent. The annual inflation rate started to climb in March of that year, shooting up to 2.6 percent before peaking in June 2022 at 9.1 percent. Since then, the CPI has slowed to 4.9 percent, and the Cleveland Fed Bank’s Inflation Nowcast expects the May CPI to ease to 4.1 percent.
Annualized average hourly earnings for all U.S. employees have been elevated throughout the pandemic as employers enticed candidates with higher pay, hovering around 5 percent. Wage gains have been gradually coming down since peaking at 5.9 percent in March 2022, coming in at 4.4 percent in April.
But real wage growth (inflation-adjusted) has been negative for the past two years.
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Soft Landing and Labor Markets
Since the central bank’s tightening cycle began in March 2022, Fed Chair Jerome Powell argued that a soft landing—a moderate economic slowdown, disinflation, and a labor market intact—is possible.
“I continue to think there’s a path to getting inflation back to 2 percent without a significant economic decline or significant increase in unemployment,” Powell said during a post-Federal Open Market Committee (FOMC) policy meeting press conference in February.
But Bernanke and Blanchard posit that the U.S. economy might need to slow further to clamp down on inflation.
“Looking forward, with labor market slack still below sustainable levels and inflation expectations modestly higher, we conclude that the Fed is unlikely to be able to avoid slowing the economy to return inflation to target,” Bernanke and Blanchard explain in the paper.
The paper states that the Fed’s 2 percent target rate could be achieved if labor market slack falls below 1 over the next two years. This metric monitors the number of job openings for each unemployed jobseeker, so if it dips under 1, it signals that more out-of-work individuals are competing for jobs than there are open positions. It presently sits at 1.6.
“Allowing (the ratio) to remain near current levels does not bring inflation down in our projections. Indeed, because an extended period of inflation raises long-term inflation expectations, it leads to slowly increasing inflation,” Bernanke and Blanchard said.
Bernanke appeared alongside Powell at the Perspectives on Monetary Policy panel discussion at the Thomas Laubach Research Conference on May 19. During the event, Powell suggested that labor market slack didn’t play much of a factor when inflation first spiked in early 2021. However, moving forward, he does believe that “labor market slack is likely to be an increasingly important factor in inflation.”
Meanwhile, despite many expectations suggesting that the unemployment rate needs to climb a few percent higher from its current level of 3.4 percent, Powell conceded during his semi-annual “Monetary Policy Report” to Congress that the labor market doesn’t need to be decimated to restore price stability.
Does this mean interest rates need to be higher? That’s the discussion many Fed officials are having.
St. Louis Fed Bank President James Bullard expects two more rate increases this year. He told an American Gas Association financial forum in Florida that “we’re going to have grind higher with the policy rate in order to put enough downward pressure on inflation and to return inflation to target in a timely manner.”
Bullard isn’t a voting member of the FOMC.
In a May 22 interview with CNBC, Minneapolis Fed Bank President Neel Kashkari, a voting member, said it was “a close call” whether to raise rates or hit the pause button at the June FOMC meeting.
According to the CME FedWatch Tool, investors mostly expect the Fed to slam the brakes on rate hikes.
But if the central bank does opt for a rate pause, it might not mean the tightening cycle is over, Kashkari says.
“Some of my colleagues have talked about skipping. Important to me is not signaling that we’re done,” he told the business news network. “If we did, if we were to skip in June, that does not mean we’re done with our tightening cycle. It means to me we’re getting more information.”
The Fed must be “extremely mindful” of when higher interest rates begin to affect the broader economy significantly, warns San Francisco Fed Bank President Mary Daly. The time “is getting nearer,” she said at an economic symposium at the National Association for Business Economics and Banque de France on May 22.
“And when you add the credit tightening that we’ve been seeing to that, it means that there’s a lot of factors pulling back the reins on the economy, and that’s why we have to be so critically data-dependent because if we think it’s not here yet and then we tighten too much, we can easily create an unforced error where we’ve over tightened.”
Article cross-posted from our premium news partners at The Epoch Times.