Stimulus Spending, Inflation, and the Recovery

Fourteen months after the country shut down in response to COVID-19, America seems to be turning the corner. Real gross domestic product will likely surpass its pre-pandemic level by the middle of this year and new jobless claims continue to fall steadily. Nearly 50% of the total population have received at least their first vaccine dose and the Pfizer vaccine has just received FDA authorization for use in children as young as 12. As the country continues to reopen, market participants have begun to consider the possible aftereffects of the unprecedented levels of monetary and fiscal stimulus that resulted in what may ultimately be recorded as the shortest recession in U.S. history. Their primary concern: inflation.

As reported in the Federal Reserve’s semiannual Financial Stability report published this month, in a survey by the Federal Reserve Bank of New York, the third most frequently cited potential shock over the next 12 to 18 months was a surge in inflation (following vaccine-resistant covid variants and a sharp rise in real interest rates). This marked a dramatic increase in concern over inflation in the same survey from just the fall of 2020, when inflation ranked 7th. Indeed, the stimulus programs enacted to ward off economic collapse have been financed by a ballooning federal debt and money supply. Meanwhile, generous unemployment assistance programs may be artificially inflating labor costs. These are conditions which could certainly contribute to an inflationary environment that proves more than transitory.

Our burgeoning federal debt has been an issue of increasing concern for many years. Even prior to the pandemic, federal debt held by the public steadily outpaced growth in GDP, leading to a rising debt-to-GDP ratio. The U.S. response to the coronavirus pandemic has been the most expensive economic relief effort in modern history: $12.8 trillion have been allowed for coronavirus economic relief, and to date, $7.4 trillion have been disbursed or committed. This has had a net impact of increasing our federal budget deficit by over $5.3 trillion. Debt held by the public is projected to total 108% of GDP this year, exceeding the previous post-World War II record of 106% of GDP in 1946. 1

Despite these unprecedented amounts of government spending, yields on 10-year Treasury securities remain below pre-pandemic levels. The market remains confident that the Federal Reserve will maintain its commitment to buy government bonds to safeguard the economic recovery. However, monetizing the debt cannot be a long-term solution, and increases in the money supply relative to the real goods and services an economy produces will eventually lead to higher price levels. The Consumer Price Index (CPI) rose 4.2% in April from a year earlier, the sharpest increase since September 2008. Some have argued that this is because of comparison to a low base as the economy was in recession this time last year, but the seasonally adjusted month over month rise from March to April was also the largest in over a decade. While there are signs that part of the recent rise in prices may be due to transitory effects, further fiscal stimulus may push monetary policymakers to be less accommodative.

Signs that fiscal stimulus may be distorting the labor market have also begun to accumulate. Though the downward trend in new weekly jobless claims shows job losses slowing, the latest monthly employment report suggests people may not be returning to work very quickly either. Anecdotal evidence abounds of employers unable to find willing workers, some even resorting to offering payments just for applicants to take an interview. Many speculate that the enhanced unemployment benefits are at least partly to blame for the labor shortage. For now, these reports appear to be concentrated in service industries with low wages and increased demand for labor caused by the economic reopening. However, if the demand for higher pay creeps into other industries before enhanced unemployment benefits expire in September, businesses may find they need to raise wages to fill job openings. Inflation could begin to creep up as businesses seek to offset these wage increases and maintain profitability.

The various monetary and fiscal support programs enacted over the past year almost certainly prevented a prolonged economic contraction. As the economy continues its recovery, the marginal impact of each additional dollar of spending must be weighed carefully, especially if it is financed with more borrowing. Taking on more debt to fund stimulus programs even as they become increasingly unnecessary could ultimately lead to an inflationary feedback loop that benefits no one.

1 Source for stimulus, deficit, and debt data: Committee for a Responsible Federal Budget.