Did Policy Error Cause the Recession?

U.S. President Joe Biden gestures as he delivers remarks on the Inflation Reduction Act of 2022 at the White House on July 28, 2022. Elizabeth Frantz/Reuters

News Analysis

The Inflation Reduction Act (IRA) of 2022 has reignited the debate over the root cause of today’s inflationary environment and recession.

From global supply chain snafus to Russia’s invasion of Ukraine, many economists and market analysts have alluded to a wide range of issues adding to the highest level of the Consumer Price Index (CPI) in 40 years. But some experts say that the source of rampant inflation was excessive pandemic-era government spending.

With inflation eating into economic growth prospects, the next discussion will be if exceptional public expenditure—from the pandemic to the IRA—have fueled the recession.

Looking Back at Fiscal Stimulus Efforts

At the start of the COVID-19 public health crisis, the federal government approved the $2.1 trillion CARES ACT, which consisted of $500 billion in direct payments to Americans, $208 billion in loans to major industries, and $300 billion in Small Business Administration (SBA) loans. At the same time, the Federal Reserve launched its multi-trillion-dollar quantitative easing program, an initiative that included purchasing government and corporate bonds and mortgage-backed securities and slashing interest rates to near zero.

In March 2020, Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, told “60 Minutes” that the central bank has an “infinite amount of cash,” leading critics to worry that the institution would print as much money as possible to ensure the financial system remained intact.

A year later, Washington voted for the $1.9 trillion American Rescue Plan (ARP). The legislation was significant because it distributed $1,400 to every American, expanded jobless benefits, extended billions in additional funds to state and local governments, and authorized emergency grants and loans to businesses.

The American people received more than $5 trillion in government transfers during the COVID-19 pandemic, including stimulus checks and sweetened unemployment benefits. The U.S. Department of the Treasury also issued approximately $6 trillion, half of which was monetized by the Fed. As a result of all this spending and borrowing, the national debt ballooned, from about $23 trillion in February 2020 to close to $31 trillion. By the time the Fed launched its tightening cycle this past spring, the central bank had added nearly $9 trillion to its balance sheet.

Will a recession thus force the Fed to rethink its rate hikes and balance-sheet reduction?

Until then, the central bank will continue to attempt to steer the economy toward a soft landing rather than a hard crash. And therein lies the main problem for the United States: After two years of easy money, the Fed is removing the punch bowl for Main Street and Wall Street, primarily through the means of higher interest rates. When rates start inching higher, recession fears build because the upward movement in the fed funds rate makes borrowing more expensive and slows down business activity.

Ringing Alarm Bells

Economists and financial experts—from the left and right—warned that the consequences of shutting down an economy and extending trillions in fiscal stimulus and relief payments to millions of Americans would lead to inflation. In other words, it was enormous demand chasing too few goods.

Bill Dudley, the former president of the Federal Reserve Bank of New York, penned an op-ed in Bloomberg that sounded the alarm of a “nasty” increase in inflation, stemming from post-pandemic demand and federal stimulus.

“All told, inflation might be a greater danger precisely because it’s no longer perceived as such,” he wrote.

“Policymakers want to push it higher. Most households and businesses are not concerned about the risks. Once the pandemic abates, those risks will no longer be entirely on the downside. And given how completely financial markets have come to expect low inflation and interest rates, and how much support those expectations are providing to bond and stock prices, an upside surprise could prove nasty.”

While speaking at a CoinDesk conference in May 2021, former Treasury Secretary Larry Summers urged the Biden administration to reconsider its stimulus efforts.

“I think policy is rather overdoing it. The sense of serenity and complacency being projected by the economic policymakers—that this is all something that can easily be managed—is misplaced,” Summers said in recorded comments at the event. “We’re taking very substantial risks on the inflation side.”

“The Fed’s idea used to be that it removed the punchbowl before the party got good,” Summers added. “Now, the Fed’s doctrine is that it will only remove the punchbowl after it sees some people staggering around drunk.”

JPMorgan Chase CEO Jamie Dimon appeared before the U.S. Senate in May 2021, warning that the “unprecedented” fiscal and monetary policies “will raise inflation.”

The Federal Reserve Bank of Chicago had also considered the effects the American Rescue Plan would have on inflation based on the debt.

“The ARP is almost entirely deficit financed, so it will substantially add to the federal debt that is already high by historical standards. Such a large increase could trigger widespread concerns about the willingness of policymakers to increase taxes or reduce spending to contain the debt,” economists at the regional central bank wrote in April 2021. “This could boost inflation today if people come to widely believe a large fraction of the debt will be inflated away instead.”

Sen. Rob Portman (R-Ohio) had also cautioned that the ARP “risks overheating an already recovering economy” that would lead to higher inflation and threaten long-term growth.

Now that analysts are crunching the numbers and assessing the situation, they see that expansionary fiscal policy played an enormous role in 40-year high inflation rate. Robert Koopman, the chief economist at the World Trade Organization (WTO), for example, noted in February 2022 that government spending inflated demand for durable goods, contributing greatly to worldwide scarcity.

Economists at the Federal Reserve Bank of San Francisco published a white paper that examined the correlation between the stimulus package and inflation.

They found that U.S. inflation had risen faster than other Organisation for Economic Co-operation and Development (OECD) countries. The Bay Area economists also noted that their models discovered that “throughout 2020 and 2021, U.S. households experienced significantly higher increases in their disposable income relative to their OECD peers,” which exacerbated demand levels.

But the Biden administration had repeatedly dismissed concerns that stimulus and relief expenditures to cushion the blow from the COVID-19 public health crisis would lead to inflation. Instead, officials claimed it was “transitory” once price inflation started creeping up.

“The vast majority of the experts, including Wall Street, are suggesting that it’s highly unlikely that it’s going to be long-term inflation that’s going to get out of hand,” Biden said at a CNN town hall meeting last summer. “There will be near-term inflation, because everything is now trying to be picked back up.”

Treasury Secretary Janet Yellen then retired the term in a congressional hearing alongside Federal Reserve Chair Jerome Powell.

While speaking in an interview with CNN, Yellen explained that she was incorrect when she thought there would be a “small risk” of inflation.

“I think I was wrong then about the path that inflation would take,” she said in May. “As I mentioned, there have been unanticipated and large shocks to the economy that have boosted energy and food prices, and supply bottlenecks that have affected our economy badly, that I didn’t at the time fully understand. But we recognize that now the Federal Reserve is taking the steps that it needs to take.”

The Biden administration is still confident that inflation will begin falling heading into the midterm elections.

Did the Fed Create Inflation?

Moreover, not everyone is giving the Fed a free pass on its role in inflation, quoting legendary economist Milton Friedman, who famously said that “inflation is always and everywhere a monetary phenomenon.”

Steve Hanke, an economist and professor of applied economics at Johns Hopkins University, told The Washington Post in February that the liquidity the Fed injected into the economy triggered an inflationary response. This, he warned, will cause inflation to linger longer than what officials anticipate and drive prices higher as the nation moves on from the pandemic.

That liquidity, the M2 money supply—a broad measurement of the money supply that includes cash, checking deposits, and easily convertible near money (such as government bonds)—soared more than 40 percent from the start of the pandemic to the peak in March 2022.

Economist Murray Rothbard explained in his seminal book, America’s Great Depression (published in 1963), that the quantity of money is not the sole component to monitor. Instead, it is important to determine where the freshly printed dollars travel and what businesses and consumers do with the funds.

For the last two years, the public has used stimulus checks to purchase stocks and acquire durable goods. Despite an economy under lockdown, and with millions out of work, the leading benchmark stock indexes hit record highs. With a desire to buy products instead of services, the global supply chain crisis was initiated, resulting in higher prices in nearly every industry.

Peak Inflation and Recession Fears

The growing expectation is that inflation has peaked. With crude oil and gasoline prices coming down from their respective peaks, market analysts are forecasting lower headline readings. But while the CPI and the Producer Price Index (PPI) fall, the consensus is that higher prices will remain elevated for a little while longer, before drifting down to the Fed’s preferred target rate of 2 percent.

Moving forward, the public discourse will surround the potential inflationary effects of the Inflation Reduction Act. Will it repeat the mistakes of the CARES Act and ARP? Will it add to inflationary challenges? Early estimates from the Penn Wharton Budget Model and the Congressional Budget Office (CBO) suggest that its impact on the inflation—and the federal deficit and the gross domestic product—will be negligible, despite the hopeful description lawmakers attached to the bill.

Even if inflation has reached its zenith, the damage may already have been done to the economy. With the personal savings rate collapsing, credit growth surging, and 7.5 million people working two jobs, consumers are extremely concerned about the cost of living. When this occurs, it leads to widespread fears and an impact on consumer demand, effectively weighing on growth prospects.

For example, fuel consumption has fallen as motorists struggled to afford prices at the pump. While the trend has allowed energy prices to come down, this has also produced demand destruction. If drivers are not willing to pay for more than $4 for a gallon of gasoline, what else are they giving up in the marketplace?

With an economy that is driven by two-thirds consumption, inflation may have become too onerous for the average consumer. Pandemic-era savings have been exhausted, and consumers are relying more on credit cards to endure this environment. The U.S. government has slimmed down its COVID-19-induced fiscal stimulus campaign, even as the country slips into a technical recession. Now American must further brace themselves to endure the next economic downturn.