There's Debate Over Stimulus Driving Inflation, But What are the Facts?

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Economic heavyweight Larry Summers’ comments about the potentially harmful inflationary effects of Joe Biden’s proposed $1.9 trillion stimulus package generated the type of pushback you’d expect from the new president’s appointees, and also drew criticism from some other experts. Given the need to get the next move right, Summers is posing a good question to his fellow Democrats.

Inflation is in the spotlight. Should we be worried?

Biden administration economist Jared Bernstein and New York Times columnist and Nobel Laureate Paul Krugman see no reason to worry. They defended the proposal and suggested that an even larger package is needed. Treasury Secretary Yellen also differed with Summers’ analysis and indicated that should inflation rear its ugly head, the Fed has adequate tools to handle the problem.

We should know by now that disagreement among economists about the effects of a massive plan to borrow and spend huge amounts is inevitable, and in some ways fosters a healthy discussion. Sometimes, differences of opinion reflect variations in critically important assumptions about the initial state of the economy and the timing and magnitude of a proposal. At other times, the differences are primarily political — “This is the party line and I am sticking with it.” In any case, the conversation is needed.

What do the data tell us?

Is there evidence that measures of inflation, such as those maintained by different Federal Reserve Banks and the Department of Commerce Personal Consumption Expenditure Index, are headed north? And if not, is there evidence that monetary forces capable of igniting those indexes are building pressure?

Consider the New York Federal Reserve Bank’s monthly Underlying Inflation Gauge. Its “prices only” component is based on movement of several hundred domestic prices, as well as those for imports and exports. Last month, the gauge registered 2.1 percent inflation, the same level seen in December 2020, and about what we’ve seen from 2017 forward.

Then there’s the Atlanta Fed’s Business Inflation Expectation Index, which provides an estimate based on surveys of what businesspeople expect to see one year ahead. February’s index pointed to 2.2 percent inflation. In February 2020, respondents expected 1.7 percent inflation. Since 2011, it has rotated around values below 2.0 percent.

We might also note the Dallas Fed’s trimmed-mean inflation measure, which removes outlying data points from the Department of Commerce Personal Consumption Expenditure Index for a more stable estimate. Most recently, it was reading 1.7 percent.

Finally, look at the gap between the yield on the 5-year Treasury note and the 10-year Treasury TIPs bond, which provides an inflation-adjusted yield and can provide an estimate of inflation expectations five years out. The result reflects actions of countless investors, and we cannot know what drives their individual decisions. What we do know is that taken together, investors expect to see 1.9 percent inflation across the next five years.

So far, so good. Measures of both current and expected inflation suggest we are sailing on smooth waters. Should we stop worrying? Perhaps not.

What does inflation theory tell us?

Here’s where we need to take a broader view, because none of these estimates account for the full effects of the December $900 billion stimulus, which is still working its way into the economy, or Biden’s proposed $1.9 trillion, which is yet to be approved. Since they are not in the data, we still can’t dismiss Summers’ inflation worry. There’s one more tack we can take on the matter.

An early theory of inflation focused on the “equation of exchange,” which holds that the amount of money circulating multiplied by its velocity — the number of times each dollar turns over in a time period — yields the dollar value of the GDP. If the amount of money in the economy increases and velocity remains unchanged, the nominal value of GDP rises, and that’s what we call inflation.

Put in the conventional way, increasing the supply of money forms the basis of future inflation. It’s where the term “inflation” originated — an inflated money supply bringing rising prices and less value for each dollar.

And what can we say about the amount and velocity of the money that has flowed recently into the economy, say in the last year? Plenty.

There are trillions in largely stimulus dollars sitting in Americans’ private bank accounts and in reserves held by commercial banks within the Federal Reserve System. Since the Great Recession and especially in the last 12 months, we have seen record amounts of money resting just outside the economy waiting to enter and be spent.

It’s like water stored behind a major dam, but not yet moving across the spillway. There’s a head of potential inflation sitting in the banking system waiting to move. If the $1.9 trillion stimulus money joins the current high balances, inflation pressures will rise even more. Even though current measures of inflation and expectations are tame, we still have plenty to worry about.

Bruce Yandle is a distinguished adjunct fellow with the Mercatus Center at George Mason University, dean emeritus of the Clemson University College of Business and Behavioral Sciences, and a former executive director with the Federal Trade Commission.

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