Wall Street Journal: How the Fed and the Biden Administration Got Inflation Wrong

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How the Fed and the Biden Administration Got Inflation Wrong

Officials applied an old playbook to a new crisis. ‘We fought the last war.’

Wall Street Journal

In recent weeks, top officials in the Biden administration and Federal Reserve have publicly conceded that they made mistakes in their handling of inflation.

Behind their errors was a misreading of the economy.

Advisers to President Biden and Fed officials worried the Covid-19 pandemic and related restrictions would bring similar consequences to the 2007-09 financial crisis: weak demand, slow growth, long periods of high unemployment and too-low inflation.

So they applied the last playbook to the new crisis. The Fed redeployed low-interest-rate policies that it believed had been effective and generally benign, and promised not to pull back prematurely. Elected officials concluded they had relied too heavily on the Fed previously, and decided to spend more aggressively this time, starting with President Donald Trump and capped off with President Biden’s $1.9 trillion stimulus.

Moreover, many Democrats saw their control of the White House and Congress as a rare opportunity to shift Washington’s priorities away from tax cuts favored by Republicans and toward expansive new social programs.

But the pandemic economy turned out to be fundamentally different.

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The pandemic has caused lasting disruptions to global supplies of a range of goods and services, causing nagging shortages and upward pressure on prices that would likely have occurred even without stimulus. While supply has been slow to rebound, demand for goods and services recovered quickly.

By December 2020, the unemployment rate had fallen to 6.7%. It had taken three years to fall to that level after the 2007-09 recession.

Policy makers didn’t change course. House Democrats in May 2020 had approved a $3 trillion stimulus bill, and continued to back that figure, citing Mr. Powell’s support for targeted aid.

Fed officials and Mr. Biden’s advisers, many of whom had served either under Mr. Obama or, like Ms. Yellen, at the Fed during the financial crisis, remained haunted by the slow recovery of the 2010s and fears that new waves of Covid could derail the nascent upturn. Moreover, inflation had been below the Fed’s goal for more than decade. This also made them confident they had the scope to act further.

“We know from the previous expansion that it can take many years to reverse the damage” of prolonged high unemployment, Mr. Powell said in a February 2021 speech.

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Democrats saw deficit-financed stimulus this time as a vehicle to advance expanded social programs, such as an enriched child tax credit they hoped to make permanent. In progressive circles, some lawmakers embraced the ideas of “modern monetary theory,” which posited that as long as inflation was low, there was no limit to how much Washington could borrow.

Mr. Biden likened his ambitions to those of Lyndon B. Johnson’s Great Society during the 1960s. “This is the first time we’ve been able to, since the Johnson administration and maybe even before that, to begin to change the paradigm,” he said after signing the stimulus into law in March.

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In December 2020, after Mr. Trump had lost the election to Mr. Biden but had not conceded, he argued for $2,000 in additional relief checks to millions of individuals. Democratic candidates in Georgia’s Senate runoff elections picked up the call.

They won, giving control of the Senate to Democrats. Progressive lawmakers pressed for fast action on stimulus.

Days before inauguration, Mr. Biden and his closest advisers agreed on the $1.9 trillion plan, which included $350 billion in aid for state and local governments, $300 a week in extra unemployment benefits through the first week of September, and, fulfilling the Georgia Democrats’ promises, $1,400 relief checks, an addition to $600 passed by Congress in December.

Some economists warned this would lead to inflation, most prominently Harvard University’s Lawrence Summers, a former Treasury secretary. He estimated monthly household income was about $25 billion to $30 billion below what it would be in a normally functioning economy. He estimated the stimulus was near $200 billion a month and would fill that “output gap” many times over. Mr. Furman joined in those criticisms.

Their criticism frustrated White House officials because both were prominent Democrats who had served under Mr. Obama. Ms. Yellen, who was new to Mr. Biden’s team, was in a delicate position. When Mr. Biden completed the $1.9 trillion proposal in January, she wasn’t in the meeting, according to people familiar with the matter.

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Until November 2021, the Fed was adding more stimulus by buying $120 billion of Treasury and mortgage-backed bonds a month. Such purchases are aimed at holding down long-term interest rates. Officials had said they would “taper” those monthly purchases to zero before starting to raise rates.

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Mr. Quarles said in hindsight the Fed should have begun reducing bond purchases last September; it phased them out between November and this past March.

Before the pandemic, Mr. Summers had warned of a chronic shortfall of demand and low inflation, a combination dubbed “secular stagnation.” But after Mr. Biden’s stimulus passed in March 2021, his concerns shifted to excess demand and inflation. The Fed’s job is to take the punch bowl away just as the party gets going, a former chairman once quipped. Mr. Summers compared the Fed’s new framework to waiting “until we see a bunch of drunk people staggering around.”

Mr. Summers was in the minority. Many professional economists, using models similar to those used by Mr. Powell and Ms. Yellen, agreed with them that the inflation surge would be transitory. In July 2021, private forecasters surveyed by The Wall Street Journal projected inflation would recede to 2.4% by the end of 2022. They now project 4.8% at year-end.

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