Inflation is Through the Roof!

The January Bureau of Labor Statistics (BLS) numbers showed a 7.1% seasonally-adjusted year-over-year increase from December 2020 to December 2021. But what does that actually mean? The United States government measures inflation by measuring changes in a metric called the Consumer Price Index (CPI). It aggregates household consumption data across the United States and sorts consumption into expenditure categories. The CPI represents an average person’s consumption bundle. This is the formula for calculating CPI:

$$ \mathrm{CPI} = \frac{\sum_{i=1}^{n} \mathrm{CPI_i} \times \mathrm{weight_i}}{\sum_{i=1}^{n} \mathrm{weight_i}} \times 100 $$

Here, a weight represents the proportion of a person’s entire consumption bundle that a certain category constitutes on average and for an expenditure category $ i $:

$$ \mathrm{CPI}_i = \frac{\mathrm{current\ period\ cost\ of\ consumption\ items\ in\ category}}{\mathrm{base\ period\ cost\ of\ consumption\ items\ in\ category}} $$

Now, we can understand the formula for the economy wide CPI: if I have n expenditure categories, the CPI is the sum of the weighted price indices for each expenditure category divided by the sum of the weights for each category. We measure inflation by taking the difference between the CPI at two different periods of time:

$$ \Delta\mathrm{CPI} = \mathrm{CPI}_{t’} - \mathrm{CPI}_t $$

where $ t $ is the starting period and $ t’ $ is the ending period.

What’s important to understand is that the CPI measures an average person’s fixed consumption bundle. It does not account for the substitution effect or the variation of consumption behavior across all people. This has two corollaries:

• Everyone experiences inflation at different rates
• The standard CPI overstates inflation somewhat because people don’t have fixed consumption bundles in the real world

Look at the Components!

Disaggregating the CPI reveals that some expenditure categories can substantially differ from the average. This is often the case with categories prone to volatile price, such as food and energy:

Energy in particular is highly volatile. To account for this, the Bureau of Labor Statistics (BLS) uses the core inflation measure. This is the CPI without energy and food accounted for. It’s considered a better long-run measure of inflation by most economists. The year-over-year inflation rate for core inflation is 5.5%, which is 1.5% less than the overall measure. The CPI year-over-year difference less energy only is 5.6%.

Right now, there’s another massive outlier: motor vehicle prices. This table shows the year-over-year inflation from December 2020 to December 2021 for motor vehicle expenditure categories:

Expenditure Category	Year-over-year inflation rate
New cars and trucks	11.8%
Used cars and trucks	37.3%
Car and truck rental	36.0%

These categories contributed to approximately 1.6% of year-over-year inflation. If we subtract energy and these categories, the year-over-year inflation is approximately 4%. That’s approximately 43.5% less than the overall year-over-year change. This accounts for transitory effects better than the full measure does right now. Note that this isn’t a perfectly accurate measure; high car price inflation likely decreased demand and prices for other expenditure categories.

Macro Impacts

4% is less than 7.1%, however, it’s still high relative to the last couple decades and European nations. This graph shows the difference in core inflation between the Euro area and the US:

How did this happen? Much larger fiscal stimulus is one of the primary factors. This graph shows real (deflated with the CPI) M2 growth rate year-over-year:

The large increase coincides with Congress passing the 2.2 trillion USD CARES Act in March 2020 and the 1.9 trillion USD American Rescue Plan in March 2021. A vast majority of both bills contained one-time spending provisions. This is why M2 growth rate precipitously declines throughout 2021. Large M2 growth would be disconcerting if it were ongoing, but looking at the data, it’s extremely clear that it was temporary. We can clearly see the difference in fiscal stimulus level by comparing Euro area and US price level increases in both durable goods and services:

There were three positive ramifications of the US stimulus packages:

• The United States is the only nation with a GDP greater than pre-pandemic levels
• The United States has the second lowest unemployment rate in the G7 at 3.9%, just 0.3% higher than in December 2021
• The United States poverty rate decreased by 2.6% from 2019 to 2020

I believe that we can substantially improve our fiscal policy response in the future, but this was arguably a net win. Despite immense political polarization, Congress responded much more effectively than the last two recessions, and it shows. It would be a grave mistake to double down on blind austerity in the future. That said, I think that at least a non-trivial portion of the stimulus did more to increase nominal prices than it did to increase real GDP growth.

Will it Keep Rising?

Future inflation levels depend on the government’s commitment to reducing the deficit and paying down debt. If we choose to commit to unabated fiscal expansion and refuse to make our social insurance solvent, then inflation probably keeps increasing at higher levels. It’ll be very painful if we don’t start acting more prudently as interest rates climb.

Most economists estimate that the overall inflation rate for 2022 be approximately 3-4%. This is because the labor market remains tight, continued demand shortfalls, and more American Rescue Plan money being spent in Q1 2022.

Micro Impacts

The microeconomic effects regarding inflation are supply-side related. The largest of these effects was producers, such as car manufacturers, drastically cutting their intermediate goods orders and even liquidating assets in some cases. When demand increased to pre-pandemic levels and beyond, these producers weren’t able to handle it. It’s hard to blame them, given how parsimonious our past fiscal responses to recessions have been. This graph shows changes in the prime age (25-64) employment using data from BLS:

This is not a normal recovery for the US, and that’s good. Giving producers confidence and certainty that the government will respond swiftly to keep the economy running as best as possible in a recession is critical to avoiding this mistake again. There were and are legitimate supply chain bottlenecks at play too. Just-in-time supply chain methodology, regulatory barriers, and COVID-19 all played their roles in causing supply chain bottlenecks.

Putting Downward Pressure on Inflation

We need sound, joint fiscal and monetary policy to keep inflation down while sustaining a healthy economic expansion. Federal Reserve Chair Jerome Powell put it well just the other day: “To get the very strong labor market we want with high participation, it is going to take a long expansion. [And] to get a long expansion, we are going to need price stability.”

Fiscal Policy

The last few recessions we’ve experienced make it clear we need to overhaul our fiscal policy. The first change Congress must make is implementing automatic fiscal stabilizers to reduce large real GDP fluctuations. Automatic fiscal stabilizers do this by increasing public spending in recessions to keep output up while cutting it during post-recession expansion. This happens without any direct intervention from policy makers. Making large reforms to the Unemployment Insurance (UI) in the US is important. This must include automatically adjusting the generosity of the program depending on our economic outlook. Arin Dube’s proposal is a fantastic option because it makes UI more effective and generous while preventing anyone from receiving more than 100% of their previous wage. Other social insurance programs should also have automatic stabilizers.

We must also integrate our fragmented low-income supports into two cash grants:

• A child allowance
• A universal grant paid to all adults

The child allowance would consolidate the non-refundable child tax credit, child and dependent care tax credit, dependent care flexible spending accounts, 529 savings accounts, the child portion of the Earned Income Tax Credit (EITC), and the head of household filing status. The adult grant would consolidate the rest of EITC, WIC (food for pregnant women and young children), TANF (cash and in-kind benefits for very poor families), LIHEAP (heating and cooling subsidies), SNAP (food stamps), Social Security Supplemental Security Income (SSI), and Housing Assistance programs. Both grants would be unconditional, subject to a single phase-out rate above a certain inflation-adjusted income level for all households. They’d also be paid monthly, which obviates the issues we saw with highly concentrated social insurance payouts in both stimulus bills.

Finally, modifying requirements for state and municipal governments to receive financial relief for recessions would help curb unnecessary spending. These requirements for disbursing any future state and municipal aid should be as follows:

• Aid must be contingent on accounting reforms with adoption delays allowed for small towns that lack sufficient staffing capacity only
  • Mandatory accrual accounting and generally accepted accounting principles
• Full repeal of the Tower Amendment
• Cooperation with the Federal government on the part of states and municipalities to establish rainy day funds with binding controls negotiated by both entities to avoid state and municipal politicians from abusing the fund for political expediency

Hard Fiscal Rules

Congress has weak procedural rules only. These are from the Congressional Budget and Impoundment Control Act of 1974 and the Omnibus Budget Reconciliation Act of 1990. These rules have no strong force as Congress can easily wave them whenever it suits the majority in power. Congress must adopt three rules to show its commitment to fiscal discipline:

• A sane budgetary target
• Microeconomic consistency with macroeconomic goals
• Pro-active spending targets

Many conservatives adamantly support a balanced budget amendment. This would be a profoundly pro-cyclical move; it would create fiscal whiplash by deepening recessions and making booms more frenetic. A smarter budgetary target would allow for fiscal stabilization while trying to keep the budget balanced over the business cycle. A good candidate is the primary structural balance of the budget. This measure accounts for business cycle variation and subtracts interest payments. Setting a hard primary structural balance target of 0.3% of GDP would avoid needless economic harm while gradually reducing the public debt-to-gdp ratio. The resulting deficit reduction would dampen inflationary pressures. In keeping with preventing macroeconomic harm, the rule should automatically lift temporarily to allow for spending beyond the target if interest rates hit the Zero Lower Bound (ZLB).

Macroeconomic consistency with microeconomic goals means Congress must be forced to structure taxes and spending such that there’s no unintentional macroeconomic harm caused as a result. This would be somewhat similar to PAYGO, but it would also prevent inappropriate austerity in addition to inappropriate fiscal stimulus. Functionally, Congress would require cyclically adjusted off-sets for spending and tax changes.

Pro-active spending targets where Congress must choose spending targets a few years in advance would constrain the desire of parties in power to increase spending or cut taxes during economic expansion. This may prove challenging to implement considering how short the Congressional cycle is. Increasing House terms from 2 years to 4 years would make this much easier, though it’s still possible to enact this rule now.

To ensure effective application of these policies, Congress should require the CBO to assess whether the government is meeting these goals, review policies in light of long-term macroeconomic goals, and provide advice where appropriate.

Monetary Policy

The monetary policy regime in the United States must change to become more effective at keeping inflation stable and unemployment low. The centerpiece of monetary policy reform is switching to a Nominal Gross Domestic Product Level Target (NGDPLT). NGDPLT has numerous positive features:

• It anchors the dollar size of the economy
  • This keeps the growth of prices, wages, and other dollar-denominated activity from expanding too rapidly
    • A corollary of this is that NGDPLT stabilizes the interaction between the money stock and money velocity, which is the number of times money changes hands over a certain time period
• It stabilizes the NGDP growth path
  • This serves to create self-fulfilling stable money spending growth expectations
• It mitigates the supply-shock problem central banks face
  • This is where central bank economists struggle to discern what kind of shock is causing inflation
• It engenders better risk sharing between creditors and lenders
  • This happens because NGDPLT effectively provides insurance against future risks that could affect debtors’ ability to repay their debts and also provides insurance against potential returns creditors might miss out on because their funds are locked up in fixed-price dollar-denominated loans.
• It reduces the risk of hitting the Zero Lower Bound (ZLB)
  • This is because NGDPLT makes up for prior deviations from the target and allows for inflation flexibility across the business cycle
    • Additionally, the kinds of expectations it gives to the public make it harder for the conditions creating a ZLB situation to arise in the first place

Regarding the specific target, policy makers should set an initial target at somewhere between 4-5%. A good NGDPLT policy allows for potential real GDP translate into changes in the trend inflation rate.

Alleviating Supply Constraints

Producers, shippers, and distributors all face some unnecessary regulatory burdens that have slowed supply chain throughput. Some policies the US must enact immediately are:

• Repealing the Jones Act
• Eliminating tariffs and trade-barriers
• Liberalizing immigration to allow for companies to deal with their labor shortages
• Automating and operating our shipping ports 24/7
• Help industry build redundancy in critical sectors