Inflation in the United States as measured by the Consumer Price Index reached its highest level in forty years during August and September 2021. Consumers face widespread shortages of items that Americans used to take for granted, from cars to smartphones. The cost of housing is rising at the fastest rate ever. Wages are rising rapidly but are unable to keep up with the cost of living, and service companies cannot find workers. What is happening to the US economy and why?
The truth is that the United States is halfway through a huge social experiment that has no historical precedent. Since the start of the COVID-19 pandemic, the federal government has injected $5.8 trillion in purchasing power into the US economy. This represents about two-fifths of the consumption component of GDP. This has led to an explosion in consumer spending, but has also led to a forty-year high rate of inflation, along with chronic shortages of basic commodities, disruptions in the supply chain, and a ballooning trade deficit.
Despite the massive stimulus, the economy is slowing down, although under these exceptional circumstances, the usual forecasting tools are ineffective. Economic forecasts have rarely varied as widely as now, at the beginning of the fourth quarter of 2021. The chart below compares the St. Louis Fed’s “Nowcast” of third-quarter GDP growth to the “Nowcast” estimate of the Atlanta Fed. Both rely on models that translate current economic data releases into GDP forecasts, yet they show strikingly divergent results. The Atlanta Fed model shows third-quarter GDP growth at just 1.2 percent. A similar model at the St. Louis Fed puts growth at 6.3 percent, close to expectations.
We do not know whether the stimulus will produce sustained economic growth with high inflation – perhaps very high inflation – or will lead to stagflation, i.e. reductions in production as well as consumption caused by inflation. The short-run behavior of GDP is determined by consumer saving and spending, according to standard models. However, the volatility of the personal savings rate has exploded over the past year as consumers have considered saving or spending. Volatility is calculated as in the graph below as the two-year standard deviation of the monthly personal savings rate (personal savings as a percentage of income) divided by the two-year average. The extreme instability in the saving rate during the last two years is unprecedented during the last sixty years. Instability turns this prediction of short-term economic behavior into an inner exercise.
The stimulus had the dual effect of increasing consumption and discouraging employment. The highest proportion in the history of the National Federation of Independent Business Survey indicates that workers are hard to find (left scale and blue line in the graph below), while the proportion of the non-institutionalized adult population in the workforce has declined sharply and has not. Retriever (right scale and orange line in the graph).
US households and companies face a degree of uncertainty unlike anything they have seen since the oil shock of the 1970s. The Federal Reserve has set the overnight interest rate at zero, which means that the real short-term interest rate is between 5 percent and 6 percent after inflation. The intent of negative real rates is to force investment out of savings into risky assets, including stocks as well as homes. It happened, in retaliation, with the fastest home price increases in US history.
Home prices have risen 20 percent in the past year, their highest ever, and rents are up between 7 percent (Zillow) and 15 percent (apartmentlist.com), according to private surveys. As current market prices for homes and rents make their way into the CPI with a lag, last year’s housing inflation heralds another 5 percent to 6 percent increase in CPI, by the back of my envelope calculation.
How will consumers respond? In the very short run, inflation causes consumers to spend money faster in order to get goods today at lower prices than they expected to pay tomorrow. But real wages are falling (down 1.9 percent year on year according to the Bureau of Labor Statistics), and inflation usually causes consumers to increase savings to make up for lost wealth.
Firms cannot raise prices fast enough to keep up with rising input costs. The widely followed Philadelphia Federal Survey of Manufacturers showed that more respondents reported higher input costs than higher prices received.
The widening gap between prices paid and prices received often precedes recessions, as occurred in 1973, 1979, 2000 and 2008. This gap does not always predict a recession (it did not happen in 1993 and 1987, for example). But it strongly suggests that corporate profit margins are under pressure. In some cases, including the American auto industry, manufacturers were able to increase profit margins significantly, because the scarcity of cars allowed dealers to cancel incentives. In general, the current inflation is likely to constrain production.
A notable development in response to stimulating massive demand is the jump in US imports from China. In September 2021, the United States imported more than $50 billion worth of goods from China, or an annual rate of $600 billion—nearly 30 percent of America’s manufacturing GDP. That represents a 31 percent increase from the January 2018 level, when President Trump first imposed tariffs on Chinese imports.
US supply chains could not meet the increase in demand caused by the stimulus, so American consumers bought more of the world’s largest manufacturer, China. The problem is a chronic underinvestment in American manufacturing. An approximate measure of the state of industrial investment in the United States is the level of demands in American firms for industrial machinery. After inflation, this measure stands at the same level as 1992, or half the 1999 peak.
In theory, China could continue to export to the United States, and continue to lend the United States money to pay for its goods, for an indefinite period. But China’s supply chains are under pressure, and rising raw material costs as well as energy prices are constraining their production capacity as well. The prices of imports manufactured in China are rising, regardless of the impact of tariffs, and this portends further inflation in the United States.
The most likely outcome, in my view, is that the largest American consumer stimulus in history will produce sustained inflation of more than 5 percent per year. Lower real wages and shrinking profit margins will continue to reduce production, and the US economy will enter a period of stagflation like the late 1970s. At some point, the US Treasury will find itself unable to borrow the equivalent of 10 percent of GDP annually, at least not at negative real interest rates. As long as investors are willing to pay the Treasury to keep their money for them, the US government can run an arbitrarily large deficit. This is the brunt of the so-called modern monetary theory. But the Herb Stein principle applies: Whatever cannot go on forever, will not. US creditors will not accept negative returns on an ever-expanding mountain of US debt indefinitely. At some point, perhaps not too long from now, the US will face sharply higher interest rates and the kind of budget constraints that were typical of profligate third world borrowers.
Reprinted from Law and Liberty