Last week’s surprisingly low employment number at a time that the U.S. economy is booming should be raising red flags about the country’s inflation outlook. Indeed, those numbers should be drawing attention to the strong likelihood that when it comes to inflation, not only does America have a demand problem but it might also have a supply problem too.
There can be little doubt that demand-side inflationary pressures are now building in the U.S. economy. At a time that monetary policy remains extraordinarily easy, as reflected by broad money supply growth of around 30 percent, the Biden administration is now engaged in the country’s largest peacetime budget stimulus on record. It is doing so even though the economy is recovering strongly and even though a considerable amount of pent-up demand was built up during the pandemic. That pent-up demand must now be expected to be released as the economy returns to some semblance of normality.
One way of gauging how inflationary the Biden administration’s budget stimulus is likely to be is to compare it with the degree to which the country’s current level of output falls short of its full-employment potential. Whereas it is now estimated that as a result of President Joe Biden’s budget policies, this year the country will get fiscal stimulus amounting to a staggering 13 percent of GDP, the bipartisan Congressional Budget Office estimates that the so-called output gap is only 3 percent. This strongly suggests that the economy could soon be overheating as a result of the Biden budget stimulus alone.
Another measure of how excessive the Biden budget stimulus might be is to compare it to the earlier Obama fiscal stimulus. While the unemployment rate in March 2009 was around 8.5 percent as compared to today’s 6 percent, the Biden stimulus was more than three times as large as the Obama stimulus.
In March 2021, at a time that all indications of demand were growing strongly, the economy added only a disappointing 265,000 new jobs. This would seem to suggest that we might already be running into labor supply shortages. So, too, would the fact that in the first quarter of this year wages grew at their fastest rate since 2003.
These labor shortages and wage increases might owe to the disincentive effects to work of the generous unemployment benefits that were introduced during the pandemic and are only due to expire in September. They also might be due to delays in school openings and to some reluctance to return to the workplace before most of the public is vaccinated.
In addition to labor shortages, the economy is also suffering from serious coronavirus-related disruptions to the global supply chain. This is particularly evident in a shortage of computer chips so vital for today’s automobile industry and for a whole range of other manufactured goods. Disruptions to the global supply chain are also giving rise to a record lengthening of delivery times as well as to sharp increases in commodity prices especially those related to the building industry.
All of this has to raise serious questions as to whether the Federal Reserve is being too dismissive of the inflationary pressures now building up on both the demand and the supply side of the economy. Federal Reserve Chairman Jerome Powell seems to believe that these factors might be largely transitory in nature and keeps repeating that the Fed is not even thinking about raising interest rates.
Unlike the Fed, the markets seem to be taking notice of the incipient inflationary pressures. This is seen in a steady rise in the market’s ten-year inflation expectation to around 2.5 percent which now is in excess of the Fed’s 2 percent inflation target.
Rising inflationary expectations should be a wake-up call to the Fed that it cannot afford the luxury to wait for actual inflation to exceed its target before it starts exiting its currently ultra-easy monetary policy stance. By waiting too long to raise interest rates, the Fed would seem to be heightening the risk of a hard economic landing next year to get the inflation genie back into the bottle.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.