How Did They Get Inflation So Wrong?
Yes, the stimulus was too big. But that’s not the main reason prices are through the roof.
Last week, Treasury Secretary Janet Yellen did something unusual for a Washington policy maker: She admitted that she’d made a mistake. In an interview with CNN’s Wolf Blitzer about the U.S.’s persistently high inflation rate, Yellen said, of her predictions last year that prices would stay under control, “I was wrong then about the path that inflation would take.”
That she was. In March 2021, when inflation hawks were arguing that the Biden administration’s $1.9 trillion stimulus plan was going to overheat the economy, Yellen called the risk of inflation “small” and “manageable,” and a couple of months later said, “I don’t anticipate that inflation is going to be a problem.” She wasn’t alone. For much of 2021, Federal Reserve Chair Jerome Powell said that he thought inflation would be “transitory,” and even as inflation rose above 6 percent, the Fed kept interest rates near zero. (Its first interest-rate hike was not until March 2022.)
Along the way, that thing Yellen thought was not going to be a problem became a huge one—not least, politically. Indeed, with today’s news that inflation in May was 8.6 percent (previously at 8.3 percent), it is arguably the biggest problem that the Biden administration faces—high prices are overshadowing pretty much everything else about the U.S. economy. The unemployment rate is a mere 3.6 percent, and last week, the Labor Department announced that the U.S. had added another 390,000 jobs in May. But all anyone wants to talk about is that average gas prices are now nearing $5 a gallon.
Yellen and Powell have, predictably, faced a barrage of criticism over their failure to keep inflation under control. When Yellen testified before Congress this week, Republican lawmakers practically lined up to say “I told you so.” But amid the recriminations, surprisingly little attention has been paid to a couple of important questions: Why did policy makers get it wrong? And what can we learn from their mistakes?
The simple answer to that first question is that the Biden administration and the Fed were, in some sense, fighting the last war—that being, in this case, the Great Recession of 2008–09. After the steep economic downturn over those two years, the U.S. economy grew at a very slow clip. From 2009 to 2016, GDP growth averaged about 2 percent a year. Unemployment, which reached nearly 11 percent in October 2009, was still above 7 percent four years later, while median wages rose only slowly.
In concrete terms, this meant that tens of millions of Americans had a miserable five years or more. And this happened even though policy makers had done quite a lot (or so it seemed then) to get the economy back on track. Democrats had passed a $787 billion stimulus plan, which at the time was the biggest such package ever enacted. And the Fed, under Ben Bernanke, had slashed interest rates to near zero and kept them there, while also trying to inject more money into the economy by buying up a wide range of assets in what was called quantitative easing. These measures did keep the Great Recession from becoming another Great Depression, but it wasn’t until 2016 that the economy really took off.
The lesson that policy makers drew from that experience was that if you wanted to get the economy moving and keep it moving, you needed to err on the side of going big. When Biden entered office in January 2021, unemployment remained stubbornly high at 6.3 percent: Although the economy had bounced back sharply from the depths of the pandemic-induced recession—thanks, in large part, to the 2020 stimulus package—the recovery in the job market seemed to have stalled. The economy actually lost jobs in December 2020. For the new administration, that raised the specter that it might be facing a repeat of the post-2009 recovery, with millions of people out of work for years to come.
In retrospect, clearly, this forecast was too gloomy. Some of the slowdown in job creation had to do with the winter COVID wave. And Congress had already passed an additional $900 billion stimulus right before Biden took office. As Larry Summers, the former head of the National Economic Council under President Barack Obama, warned last year, that made the case for another huge stimulus package much weaker, and the risk of inflation greater.
Here, too, history shaped the administration’s response. Although the 2009 Obama stimulus plan had been enormous by historical standards, and was decried by Republicans as outrageously irresponsible, it was, in fact, less than half as big as many of Obama’s own economic advisers thought it needed to be. (Famously, the economist Christina Romer put together an estimate saying that the stimulus should be about $1.8 trillion, but Obama never even saw it, in part because none other than Summers thought it was too far outside the bounds of political reality.) The lesson, as a Biden-administration official told the Financial Times, was, “Of course there are risks associated with going big, but as we’ve said all along, those risks pale compared to the risks of going small.”
On top of all this, downplaying the risk of inflation was easy because previous prophecies of doom had all turned out wrong. The 2009 stimulus and the Fed’s relatively loose monetary policy had inflation hawks insisting that “high-grade monetary heroin” was being injected into the system, which was likely to ignite “out-of-control inflation.” In 2010, with unemployment near 10 percent, a group of 23 economists, hedge-fund managers, and academics wrote an open letter to Bernanke, arguing that quantitative easing risked “currency debasement and inflation” and should be discontinued. In 2014, with Yellen then in charge, the Fed was still attracting criticism for being inattentive to prices—despite inflation being at a mere 1.8 percent.
Inflation hawks, in other words, were the proverbial boys who cried wolf. Their warnings that inflation was right around the corner were worthless because they always said that inflation was right around the corner. And the consensus among center-left economists—with the exceptions of Summers, and Olivier Blanchard and Jason Furman, two other liberal economists who warned in spring 2021 of inflationary risks—was that the risks attached to a further stimulus package were low and the potential benefits were high.
Was this wrong? Yes—but whether it was irresponsible is not obvious. Economic policy making, after all, is always a matter of balancing risks and rewards, and the potential for sustained high unemployment was very real. (Summers himself also said last year that “the dangers of doing too little are greater than the dangers of doing too much.” He just believed that $1.9 trillion was, as it were, much too much.) At this point, the contention that the stimulus package was bigger than it needed to be—or at least, could have been better directed—seems inarguable, but equally true is that it probably accounts for only a fraction of the current inflation rate. Europe, after all, did far less in the way of fiscal stimulus than the U.S., yet inflation within the European Union is now about as high.
Some of that inflation may be imported from the U.S., thanks to higher American demand for goods. But much of it reflects factors that were hard, if not impossible, to foresee in early 2021. These include the persistence of supply-chain problems due to the continuation of the pandemic, and the war in Ukraine.
More to the point: Although saying anything good about the current state of the economy without being attacked as out of touch has become impossible, ignoring the fact that the Biden stimulus plan and the Fed’s decision to keep interest rates low got millions of people back to work much faster than they otherwise would have is plain silly. (The U.S. economy has created approximately 9 million jobs since January 2021.) Skeptics of the stimulus insist that this would all have happened regardless, but that’s a quintessential case of a successful solution to a problem making the problem appear to have been nonexistent in the first place.
Of course, in a political sense, none of that really matters. Biden can talk about all the people who have jobs who otherwise would still be on the dole, and about all the workers at the lower end of the job ladder who have seen the sharpest increases in wages over the beginning of 2021, but that message can’t compete with the anxiety and anger induced by high prices. What policy makers got most wrong may, in the end, prove to be not the risk of inflation but, rather, how miserable we’d feel about the inflation itself.