Amid falling real wages, household debt and the looming prospect of a recession, the inflation problem is now firmly in the arena of US partisan politics. It’s yet another issue defined by clear political divisions between Democrats and Republicans. And like many other partisan conflicts, a politically motivated understanding of inflation threatens Washington’s ability to develop a cohesive response.
On June 15, the Federal Reserve severely suppressed inflation. Along with a 0.75 percentage point rate hike, the largest since 1994, the Fed also signaled that rates could top 3% by the end of the year. Amid growing consumer pessimism about the future of price stability and the prospect of a recession, the Fed is taking significant steps to stabilize the ship. On the same day as the rate hike, the United States reported a 0.3% decline in retail sales in May and a 14.4% collapse in housing starts.
Given the high stakes of the inflation issue, the partisan blame game is not surprising. This inevitable drive to simplify and exploit the causes of rising prices for political gain undermines Washington’s ability to develop a cohesive federal response.
For progressives, price gouging and corporate greed are the main cause of inflation. More than 50% of companies in a recent survey admitted to raising prices more than necessary, which explains why, despite rising costs, US non-financial companies have recorded their biggest profits since 1950 in the last two quarters.
Yet this mark of corporate greed is a symptom rather than a catalyst for price increases. Janet Yellen, US Treasury Secretary, recently argued that although profits have risen, “demand and supply are largely driving inflation.”
Meanwhile, demand growth is being driven by high savings among some US citizens. This is yet another reason why companies have the flexibility to raise prices. Yet, as Yellen pointed out, such behavior remains a reaction to inflation, not a major reason for it.
The Biden administration has sought to explain the high prices as a consequence of Russia’s invasion of Ukraine. Dubbed “Putin’s price hike”, the war has certainly rattled global supply chains. However, prices increased dramatically even before Russian President Vladimir Putin launched his invasion of Ukraine in February. After inflation crashed to 0.1% in May 2020, during the Covid-19 shutdowns, price growth accelerated once pandemic restrictions eased; the consumer price index stood at 7.5% in January.
President Joe Biden is correct that rising energy costs accounted for about 70% of the increase in inflation from February to March. But even without energy costs rising, inflation over the past year would be 7%. War is an aggravating element that has struck at the worst possible time. While we can’t say what inflation might be like without the war in Ukraine, the engines of rapid price growth were clearly in motion before Putin’s invasion.
Republicans, unsurprisingly, blame President Biden and his overly generous Covid-19 stimulus policies. According to their argument, cash transfers to individuals and businesses have artificially increased the purchasing power of consumers, which has spurred inflation. The stimulus, which began with President Donald Trump’s $4 billion package and continued with Biden’s $1.9 billion US bailout, was clearly not perfect.
Still, critics must remember that the lockdowns have sent the US economy into a tailspin. Without the drastic stimulus, the percentage of Americans in extreme poverty would likely have doubled and the economy might have been on course for a depression-level contraction. Doing too much was probably better than doing too little.
Economists have tended to believe that the stimulus induced some of the inflationary pressure. The magnitude of this, however, is massively overstated by Republicans. European countries, without such large cash transfers, have also seen inflation soar to over 7%.
The most compelling explanation for inflation is the one little talked about in partisan politics: lockdowns. The impact of shutting down much of the US economy while simultaneously disrupting global supply chains is hard to overestimate. Pent-up demand from consumers saving money during shutdowns has led to increased spending once the economy reopens. Meanwhile, supply chains were still preparing to meet the high post-lockdown demand. It is these mechanisms that offer perhaps the best explanation for the persistence of inflation.
Despite comments from some economists, including Yellen, about a large “savings buffer” that can protect consumers and the economy, this may be overly optimistic. A MIT study found that savings are highly concentrated among the top 10% earners. Overall savings numbers that look healthy should not be used as an indication of what the economic experience is like for tens of millions of people.
A Gallup poll recently reported that 71% of US households earning less than $40,000 said inflation was causing severe or moderate hardship. The figure is only 29% for households earning more than $100,000. Evidence that a significant portion of the American working class is struggling is also indicated by rising credit card debt.
The singular focus on the inflationary pressure of the stimulus risks overestimating the financial well-being of the median American. However, focusing solely on corporate greed or war in Ukraine similarly denies that there are endogenous forces driving inflation. At a time when consumer expectations for price growth are likely to be partly self-fulfilling, a balanced understanding of what drives inflation will be key to keeping it under control.
Julian Jacobs is an economist at OMFIF.