The Fed misjudged the economic effects of pandemic-era fiscal programs, which explains why many failed to accurately forecast the inflation that resulted from the stimulus and relief measures, including the March 2020 $2.2 trillion CARES Act, the December 2020 package that consisted of $900 billion in COVID-related spending, and the March 2021 $1.9 trillion American Rescue Plan.
The CARES Act, signed by former President Donald Trump, was sufficient enough to strengthen businesses’ and households’ balance sheets and support their ability to spend in the future, the paper claims.
“Overall, as a share of GDP [gross domestic product], the headline costs of these three COVID-era fiscal packages were about 4-1/2 times the size of the American Recovery and Reinvestment Act (ARRA), enacted in response to the 2008 financial crisis and the ensuing recession,” Bernanke and economist Olivier Blanchard wrote in the academic paper, titled “What Caused the U.S. Pandemic-Era Inflation?”
However, looking back at the COVID-19 pandemic, Bernanke and Blanchard asserted that the inflation bursts were driven by several shocks, such as the dramatic rise in commodity prices, demand shifts (from services to goods), and labor tightness.
But while the economists conceded that wage growth had little effect on inflation in early 2021, the paper states that labor costs increased over time and have become more entrenched in current inflationary pressures.
“The effects of tight labor markets have begun to cumulate,” the paper reads, noting that they'll likely “grow and will not subside on its own.”
“The portion of inflation which traces its origin to overheating of labor markets can only be reversed by policy actions that bring labor demand and supply into better balance.”
As a result, the Fed has more work to do to curb inflation.
“Labor market balance should ultimately be the primary concern for central banks attempting to maintain price stability,” the paper reads.
Bernanke now serves as a distinguished senior fellow at the Brookings Institution. Blanchard, who previously worked as the director of the International Monetary Fund’s Research Department, is a senior fellow at the Peterson Institute for International Economics (PIIE).
In January 2021, the consumer price index (CPI) was 1.4 percent. The annual inflation rate started to climb in March 2021, shooting up to 2.6 percent before peaking in June 2022 at 9.1 percent. Since then, the CPI has slowed to 4.9 percent, and the Cleveland Fed Bank’s Inflation Nowcast expects the May CPI to ease to 4.1 percent.
Annualized average hourly earnings for all U.S. employees have been elevated throughout the pandemic as employers enticed candidates with higher pay, hovering at about 5 percent. Wage gains have been gradually coming down since peaking at 5.9 percent in March 2022, coming in at 4.4 percent in April.
Soft Landing and Labor Markets
Since the central bank’s tightening cycle began in March 2022, Fed Chair Jerome Powell argued that a soft landing—a moderate economic slowdown, disinflation, and a labor market intact—is possible.“I continue to think there’s a path to getting inflation back to 2 percent without a significant economic decline or significant increase in unemployment,” Powell said during a post-Federal Open Market Committee (FOMC) policy meeting press conference in February.
But Bernanke and Blanchard posit that the U.S. economy might need to slow further to clamp down on inflation.
“Looking forward, with labor market slack still below sustainable levels and inflation expectations modestly higher, we conclude that the Fed is unlikely to be able to avoid slowing the economy to return inflation to target,” Bernanke and Blanchard wrote in the paper.
The paper states that the Fed’s 2 percent target rate could be achieved if labor market slack falls below 1 over the next two years. This metric monitors the number of job openings for each unemployed jobseeker, so if it dips below 1, it signals that more out-of-work individuals are competing for jobs than there are open positions. It presently sits at 1.6.
“Allowing (the ratio) to remain near current levels does not bring inflation down in our projections. Indeed, because an extended period of inflation raises long-term inflation expectations, it leads to slowly increasing inflation,” Bernanke and Blanchard said.
Does this mean that interest rates need to be higher? That’s the discussion many Fed officials are having.
Bullard isn’t a voting member of the FOMC.
According to the CME FedWatch Tool, investors mostly expect the Fed to slam the brakes on rate hikes.
But if the central bank does opt for a rate pause, it might not mean that the tightening cycle is over, according to Kashkari.
“Some of my colleagues have talked about skipping. Important to me is not signaling that we’re done,“ he told the business news network. ”If we did, if we were to skip in June, that does not mean we’re done with our tightening cycle. It means to me we’re getting more information.”
“And when you add the credit tightening that we’ve been seeing to that, it means that there’s a lot of factors pulling back the reins on the economy, and that’s why we have to be so critically data-dependent because if we think it’s not here yet and then we tighten too much, we can easily create an unforced error where we’ve over tightened,” she said.