Government stimulus is a direct cause of rising inflation

Prices today are rising at their fastest pace in decades and American concern about inflation is growing. While some amount of inflation can be the result of a healthy and growing economy, rapid, sustained inflation harms American families by wiping out their wage gains and eroding savings. Inflation can also rock consumer confidence, which hurts U.S. businesses endeavoring to rebuild after the pandemic recession.

Considerable debate exists over whether recent inflation is transitory or if it is a more concerning type of systemic inflation. On one hand, inflation might be a temporary phenomenon caused by the reopening of the global economy. The United States is ahead of many other nations in its recovery and supply chains are taking time to recover from over a year of sustained disruptions. On the other hand, rising inflation may be the direct result of government stimulus, which significantly increased household income and demand at a time when labor markets and other business functions remain below their pre-pandemic strengths.

After surveying the evidence, this paper concludes that rising prices are likely a mix of transitory inflation and more lasting inflation caused by government stimulus. While increased costs for American producers will likely subside after global supply chains adjust, demand-driven inflation may be exacerbated even further if government stimulus continues to boost household income before the labor market recovers. Tax increases that further constrain business activity could also make inflation worse.

Background

Faced with an unprecedented pandemic and economic downturn in 2020, the federal government responded with an unprecedented fiscal and monetary response. Since the pandemic began, Congress has authorized $6 trillion in new spending as part of the American Rescue Plan, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, and other legislation. The Federal Reserve has simultaneously purchased over $4 trillion of new assets to inject capital and liquidity into the market. In turn, federal debt rose substantially and is currently equal to the size of the economy, standing at almost 100 percent of GDP.

The Federal Reserve’s monetary response was swift and has been sufficiently accommodative, especially combined with Congress’s initial pandemic aid that helped stabilize household income during the worst of the recession. After multiple spending packages, these measures ended up overcorrecting for the downturn by boosting income and savings above what they would have been absent a pandemic.

Yet, over a year after the recession officially ended, Congress continues to pursue massive new government spending measures—including a $3.5 trillion budget resolution, the single largest spending package in history.

If legislators continue pushing government spending to new heights, they should be aware of the costs. These costs go beyond the simple sticker price of new spending. For instance, government investment has well-demonstrated opportunity costs and in many cases replaces relatively more productive private investment to the point that the private sector shrinks.

Furthermore, large government spending packages are usually accompanied by tax increases which reduce economic growth by depressing employment and investment. One study finds that, if the $3.5 trillion budget resolution boosts productivity in line with historical norms, the effect of the corresponding proposed tax increases eliminate any benefits of the government investment, decreasing economic growth only five years after its enactment.

Lawmakers should also be aware of the additional risks that swelling government spending poses to American families. The most pressing risk today is rising inflation. While monetary tightening serves as the traditional tool to prevent inflation, future monetary tightening may not be effective if extraordinary spending patterns continue.