In an overstimulated US economy, will inflation really be transitory?

Thanks to government support, many are being paid not to work. There are fears the Fed has distorted economic activity and laid a foundation for high inflation
As the US has had no significant inflation for two decades, most Americans are unaware how debilitating it can be

Barry Wood

Published: 1:30am, 13 Jun 2021

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US Federal Reserve chairman Jerome Powell is staking his reputation on the current spike in inflation being transitory. Powell and his colleagues on the Federal Open Market Committee believe that the US economy is still reeling from the Covid-19 pandemic and requires continued, unprecedented monetary and fiscal support.

Powell is undeterred by first-quarter annualised GDP growth of 6.4 per cent, pointing instead to the economy being 7 million jobs short than before the pandemic.

Accordingly, the Fed is keeping the monetary spigots wide open, holding short-term interest rates near zero and ballooning the money supply by buying US$120 billion of securities every month. Powell remains committed to holding the short-term Fed funds rate at the current emergency level until 2023.

But could Powell be wrong? Yes, of course, proclaim a growing chorus of economists, led by Larry Summers, the Treasury secretary under Bill Clinton who was once considered for the position Powell occupies.

Summers fears the economy is overheating and coming to the boil. Already, consumer prices are up 4.2 per cent year on year, the fastest pace in 12 years and two percentage points above the Fed’s target. With the Biden administration spending US$4 trillion in stimulus, says Summers, it is pursuing “the least responsible” fiscal policy in four decades.

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In main street America, help-wanted signs abound whether in Des Moines, Rockville or Racine. There’s little doubt the economy is distorted and overstimulated. Warren Buffett, the 90-year-old sage of Omaha, says 85 per cent of the economy is “running in super high gear”.

We’ve resorted to helicopter money: three rounds of government cash floating down from the sky into bank accounts. Combined with expanded unemployment assistance, many workers are being paid at a rate of US$35,000 annually not to work. Covid-19 benefits often exceed pre-pandemic pay.

Jamie Dimon, head of JPMorgan Chase, the country’s biggest bank, says overgenerous government support is a disincentive to work. Simultaneously, we have labour shortages and 6 per cent unemployment.

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The Biden administration says distortions in the labour market are also transitory. Commentator Martin Sandbu agrees. He writes in the Financial Times that because fiscal support will be withdrawn as the pandemic abates, the US is about to experience “the mother of all fiscal tightenings”.

What about the undeniable signs of inflation? Commodity prices have soared and not yet fed through into the economy. Timber is up 400 per cent, and ocean shipping rates are the same. Grocery prices are up, and petrol is at a seven-year high. We may be approaching a new housing bubble as home prices are up 14 per cent. The housing boom results from record low mortgage interest rates.

Jim Grant, who writes Grant’s Interest Rate Monitor, has long argued that the interest rate is the most important price in capitalism and that today it is at its lowest level in hundreds of years. Savers of course are punished because, adjusted for inflation, interest rates are negative.

Grant worries that the Fed has distorted economic activity and laid a foundation for high inflation. Bear in mind we’ve had no significant inflation for two decades, meaning most Americans are unaware how debilitating it can be.

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As we reach the midpoint of 2021, the stock market remains near a record high. The bull market in equities has gone on for 12 years, the longest in US history and there has been only one brief 10 per cent correction in February 2020. Is a bear market coming?

Alarmed at the hugely stimulative monetary policy, bond guru Bill Gross, co-founder of Pimco, wonders if Powell “changed his conservative clothes and unleashed the potential for chaotic future economic and market outcomes”.

Grant tells the tale of William McChesney Martin, who served as Fed chairman for a record 19 years. In the mid-60s, Martin was summoned to Lyndon Johnson’s Texas ranch to be ignominiously reprimanded for having raised the discount rate by half a percentage point.

It was the middle of the Vietnam war and Johnson was pursuing “guns and butter”, spending heavily on war as well as social programmes. Martin told the president he couldn’t do both without triggering severe consequences, to no avail.

Sure enough, in 1966, inflation doubled to 3.8 per cent, a precursor to the high-inflation 1970s when it averaged 6.3 per cent. At a retirement party in 1970, Martin lamented that, “I’ve failed.” The remark reveals the extent to which Martin was haunted by the Fed’s failure to act decisively early on to contain inflation. Will the same be said of Powell? We’re likely to have an answer in 2022.

Barry D. Wood is a journalist, author and educator