Sharp changes in trade policy and the potential for another round of elevated inflation demand a look at how the interaction of fiscal and monetary policy can lead to persistent inflation.
With inflation well above the Federal Reserve’s 2% target and rising, and expansionary fiscal policies about to kick in, calls for rate cuts may be premature.
Cutting rates while inflation is still rising tends to hurt real disposable income and bond valuations and create conditions for a weak dollar. In addition, if investors conclude that the Fed is unwilling to intervene in the economy to maintain price stability on a sustained basis, inflation expectations may rise further, and persist.
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Given the pressure to cut rates, it is conceivable that the Fed will fail to keep inflation expectations entrenched or, as the central bank likes to say, “well anchored.”
Calls for rate cuts from the fiscal authority then make the Fed’s dual mandate of maintaining price stability and maximum sustainable employment all the more difficult to achieve.
What’s more, recent research by the economist Alberto Cavallo indicates that, excluding shelter, the U.S. economy has likely experienced a broad-based increase in inflation trends.
That work presents evidence of a turning point in February 2025, with sectoral inflation accelerating significantly despite stable aggregate inflation measures.
If true, then premature calls for rate cuts would send prices higher and remove the pillar that permitted the Fed to hike rates during the 2021−22 inflation episode without causing a recession.
But when higher tariffs, a tightening labor supply through immigration policy and expansionary fiscal policies are added to the mix, the Fed’s job becomes even more difficult.
This is all occurring just as the Fed was navigating the so-called last mile of pushing inflation down to its 2% target from the pandemic highs.
Now, the imposition of tariffs has the potential to create another inflation shock. We know how the Federal Reserve should and will most likely respond: with monetary policies that are restrictive enough to keep inflation in check.
But it’s a different story with the fiscal authorities, which in our view will promote spending and higher rates of inflation.
In the discussion that follows, we first describe the postpandemic inflation shock as analyzed by former Fed Chairman Ben Bernanke and economist Olivier Blanchard. Their model explains how inflation was initially caused by the shortage of goods during the pandemic, with a tight labor market explaining its persistence.
For this latest episode, we discuss the role of fiscal stimulus programs and the postpandemic spending spree as adding to the inability of Fed policy to fully achieve its 2% inflation goal.
An empirical model of inflation shock
Bernanke and Blanchard attributed the elevated U.S. inflation during the pandemic to price shocks and sectoral shortages. Once the supply chains normalized, the tight labor market helped keep inflation elevated.
Their research was then adapted by 10 central banks among the developed economies, including Japan, Canada, the United Kingdom and the major economies within the euro area.
Teams of economists in those 10 central banks came to “wide agreement that the pandemic-era burst of global inflation was due primarily to a succession of adverse shocks to prices—notably global increases in energy and food prices and supply disruptions in key sectors.” By March 2024, those shocks had receded, accounting for most of the global cooling of inflation.
After that cooling, though, strong aggregate demand together with constraints on the labor supply helped keep inflation elevated.
The result was the inability to reduce inflation down to its 2% target, Bernanke and Blanchard concluded.
The role of fiscal policy
There is no guarantee that monetary policy and fiscal policy will have consistent objectives. Given that we have entered a period of fiscal dominance, it is essential that we understand the way in which fiscal policy can cause persistent inflation.
We contend that while fiscal stimulus before and during the pandemic era played an important role in the economy’s rapid recovery from the pandemic shock, the subsequent increase in consumer spending contributed to the persistence of inflation.
During the pandemic, the government’s fiscal authority invested in the economy’s infrastructure and maintained and even increased income levels for low-income households whose employment was most vulnerable.
At the same time, the monetary authority reduced interest rates to near zero, fostering increased investment in productivity.
It was the income assistance that became a point of contention. In the view of some, government spending on programs like income assistance leads to waste, inefficiency and, inevitably, inflation.
But this view takes an overly simplistic view of the pandemic-era inflation.
In our view, the persistence of inflation was made worse by the tax cuts that first took effect in the 2019 tax year and fiscal policy put in place through 2021 that resulted in too much money chasing too few goods as the global economy reopened following supply chain shutdowns.
And while the pandemic-era income assistance programs maintained low-income spending during the health crisis, the tax cuts contributed to the surge of postpandemic spending by upper-income households, the main beneficiaries of those cuts.
We contend that this spending kept upward pressure on consumer prices longer than would have otherwise been expected.
Spending and inflation
Very simply, without spending, there is no inflation.
Paul Volcker, the former Fed chairman, famously figured this out in 1980, when the Fed put a stop to 14% inflation by pushing interest rates to nearly 20%. The cost of that policy, however, was the sharp drop in spending and the severe double-dip recessions of the 1980s.
In this current episode, the Fed should be applauded for its response to inflation, its role in increasing productivity and its engineering of a soft landing that avoided the need for an outright recession.
As household spending increased to record levels in the immediate postpandemic years, the personal consumption expenditures index, the Fed’s preferred measure of inflation, jumped to more than 6% in 2021 and 2022. The Fed responded by pushing the policy rate from near zero to 5.5%.
But the spending was not evenly distributed.
Household expenditures data through 2023, compiled by the U.S. Bureau of Labor Statistics, shows that while the increase in household spending coincided with the increase in inflation in 2022−23, it was not the low-income households that were doing the spending. It was the upper-income households that went on a shopping spree, bulking up in home gyms and installing new kitchens.
In 2023, households in the top income quintile spent $150,000—4.4 times as much as those in the lowest quintile, which spent $34,000. (Research by the U.S. Census Bureau showed that the child tax credit payments were spent predominantly on food, followed by clothing, school supplies and rent.)
Keep in mind that the top two quintiles accounted for 62% of overall household expenditures in 2023, while the lowest quintile accounted for less than 9%.
Spending by households in the lowest quintile grew by 17.6% from 2020 to 2023, an average rate of 5.5% per year.
Spending by the top income quintile increased by 30.7% in absolute terms from 2020 to 2023, an average rate of 9.3% per year.
The takeaway
Research at 10 central banks confirmed Bernanke and Blanchard’s findings that shortages and price shocks drove the initial surge in global postpandemic inflation, while tight labor markets contributed to its persistence.
The pandemic-era income assistance programs show the benefits of fiscal policy when economic growth bottoms out. But the fiscal authorities have yet to recognize how the extreme divergence in income can become an inflation issue in what is undeniably a K-shaped economy, in which different parts of the economy recover at different rates after a downturn.
We now think that the U.S. is at the precipice of another round of elevated inflation. This comes at a time when the fiscal authorities have approved additional unfunded expansionary fiscal policy, which will lead to increased public debt, a higher cost of capital, an increased cost of credit and a weaker dollar, all adding up to higher prices.
