Written by Ben Iorio
In March of 2020, the Federal Reserve responded to the COVID-19 pandemic by injecting $2.3 trillion USD into the economy. This mass influx of money from the Federal Reserve came in the form of emergency lending programs, asset purchases, decreased requirements on banks, and a near zero interest rate. Beginner and intermediate macroeconomics students are taught the graph below, which highlights the fact that increasing the money supply decreases the demand for money. Thus, an economy is left with inflation, or in cases like Zimbabwe and Venezuela in recent years, hyperinflation. So why then did the annual Consumer Price Index (CPI) released in July show an annual inflation rate of only 1.0%? Moreover, why in March and April, when the Federal Reserve was pumping trillions of dollars into the economy, was the monthly CPI reported by the Bureau of Labor Statistics -0.4% and -0.8% respectively?
A brief history of the US dollar and inflation.
Under Nixon in the 70s, the US shifted from a gold standard currency to a fiat currency, or a currency where its value is backed by the government and individuals’ demand for that currency rather than its raw utility (like gold or silver). The shift allowed the Federal Reserve to conduct monetary policy as a way to provide stability during business cycle shifts but also created the risk of hyperinflation from rampant money printing. In countries like Zimbabwe – in the early 2000s – and more recently Venezuela, unrestricted money printing led to hyperinflation and a complete devaluation of their currency. Printing like this leads to decreased purchasing power for citizens and can greatly damage domestic economies. While hyperinflation is clearly bad, most economists agree that a small level of inflation can actually be beneficial. The Federal Reserve has been targeting an approximately 2% annual inflation rate since the 1990s and 2% has become the standard for central banks around the world (St. Louis Fed). Using the Federal Funds Rate and increasing or decreasing the money supply, the Federal Reserve sets out to reach its 2% target while also aiming for maximum employment.
How is inflation calculated?
Inflation is measured as an increase in the value of a set bundle of goods between two time periods. The two most common bundles used are the Consumer Price Index (CPI) and the Personal Consumption Expenditures price index (PCE). Both show relatively similar trends in inflation but each has different weights for different goods and CPI excludes expenditures that are not paid directly by the consumer while PCE includes them (i.e. medical insurance provided by employer or Medicare/Medicaid; Cleveland Fed). Furthermore, the CPI tends to report higher inflation than the PCE (Worth noting, the Federal Reserve uses the PCE as its target for inflation). Below are graphs for both the PCE and CPI over the past decade, trimmed mean PCE data is from the Dallas Fed and is up until June of 2020 while CPI data (or more specifically CPI-U data) is from the Bureau of Labor Statistics and is up until July 2020.
Back to what happened?
So why, six months after the largest Federal Reserve stimulus package ever, has the US not seen a spike in inflation? The answer lies in the demand for US dollars. When the pandemic hit we saw one of the largest drops in the stock market since Black Monday and a sudden massive increase in unemployment. Furthermore, individuals were no longer going out to restaurants and stores. In economics, this decrease in demand amounts to individuals holding on to their money. It is less beneficial to invest and employ than it is to save. Econ 101 teaches us that a decrease in demand leads to lower prices and that’s exactly what happened in the US. The US was, and maybe still is, experiencing deflation.
Deflation, or an increase in the demand for the US dollar (as opposed to goods or assets), offsets any short term inflationary effects from the Fed’s $2.3 trillion dollar stimulus package. What about in the long run? Surely with an extra $2.3 Trillion dollars in the US financial system prices must increase, right? This is not necessarily true. It is still unknown when the COVID-19 pandemic will pass and individuals will be less hesitant to save and more willing to spend. Furthermore, since the crisis, the Federal Reserve’s balance sheet has ballooned from around $4 trillion dollars to over $7 trillion dollars. As the securities in the Fed’s balance sheet mature, money will slowly be removed from the US economy, decreasing the money supply and reducing the chance of inflation. Results could be similar to the aftermath of the 2008 financial crisis, where quantitative easing was not followed by high levels of inflation. Not everyone is as optimistic, however, as Morgan Stanley’s chief economist Chetan Ahya was quoted saying, “We see the threat of inflation emerging from 2022 and think that inflation will be higher and overshoot the central banks’ targets in this cycle. This poses a new risk to the business cycle, and future expansions could also be shorter.” The long term inflation effects of the Federal Reserve’s stimulus plan are yet to be completely discovered, but there is more complexity to understanding the results than one would expect.
Going Forward
The Federal Reserve’s $2.3 trillion stimulus package provided much needed relief to a freezing economy when the pandemic began. What followed was months of deflation that would have been worse had the Federal Reserve not acted as quickly. Currently, the PCE and CPI are showing slight increases but we will not know the long term effects of the stimulus package for some time. Should the pandemic not end soon, and the demand for goods and assets not increase in the coming months, it is likely that we will not see inflationary effects from the stimulus package in the near future. Since the stimulus package, the stock market has almost returned to normal (until last week), unemployment has slowly decreased but still remains at very high levels, and many businesses are still struggling to stay open. Because, monetary stimulus can only do so much, it now falls on Congress to pass fiscal stimulus to help pull the rest of America out of the pandemic economy.