This is the last in a series of articles regarding monetary and fiscal policy as the economy restarts within a changing framework of labor force choices, automation and pricing. The first article examined the Fed’s challenge in meeting its mandate for full employment. The second looked at the Fed’s other mandate, for price stability. The third discussed the natural rate of interest and its impact on Fed policy.

There is no doubt that the economy has made a powerful recovery.

The decision by the Federal Reserve and Congress to reflate the economy through real negative interest rates, large-scale asset purchases and a historic increase in government spending has largely achieved its goals.

The recovery is an extraordinary achievement considering the state of the economy in April 2020, when 22 million people were out of work.

Unlike what occurred following the financial crisis in 2008 and 2009, policymakers today have learned a lesson about responding to an economic crisis.

Yet the decision by the monetary and fiscal authorities to let it rip, in conjunction with longer-term disruptions to global supply chains, has created an imbalance between supply and demand.

And this has in turn created a type of demand-pull inflation—think one part driven by demand and a larger part driven by supply chain-induced shortages—that the economy has not experienced in decades.

However challenging the recent rise in inflation may now appear, the decision to respond so aggressively to the shock of the pandemic was, in our estimation, correct. The risks to the outlook around inflation are far better in this recovery than the risks after the financial crisis, which was characterized by an extended period of elevated unemployment, weak growth and declining mobility.

Now, as monetary and fiscal policies move toward normalization, the chance that the Fed could move too aggressively to increase interest rates is, along with the pandemic, the primary risk to the economic outlook.

Dramatic recovery

The unemployment rate has declined from a peak of 14.7% earlier in the pandemic to 3.9%. It took eight and a half years after the financial crisis for the unemployment rate to decline to 3.9%. We anticipate that rate will head below 3.5% by the end of the year.

This time around, Congress and the Federal Reserve unleashed sustained financial support that is only now fading.

As a result, economic activity has surpassed its pre-pandemic peak and the economy is expanding faster than the long-term 1.7% pace of before the pandemic. Last year’s growth rate was 5.7%, and we expect a 3% to 4% rate this year.

This is an extraordinary achievement considering the state of the economy in April 2020, when 22 million people were out of work and the economy was shutting down.

The policy options at that time were stark, and we would use the same aggressive response again despite the current challenge of inflation. Repeating the policy errors that followed the financial crisis were non-starters.

The importance of stimulus

In policy terms, the quick recovery after the shock of 2020 is testament to the role of monetary policy and government spending in times of crisis. Given that presidents and houses of Congress controlled by both parties played a role in this, as President Richard Nixon famously put it 50 years ago, we are all Keynesians now. There is a time and place for government intervention into the private sector economy.

There is a time and place for government intervention into the private sector economy.

In terms of monetary policy, once the unemployment rate declined below the Federal Reserve’s definition of full employment of 4% and inflation was low enough to pause the Fed’s normalization program at the end of 2018, that turned out to be fortunate given the profound shocks that would hit the economy more than a year later.

After the economic shock of March 2020, the Fed flooded the money markets with the cash needed for day-to-day commercial market activity. It also dropped its overnight rate to zero, introducing negative long-term interest rates and virtually eliminating the cost of capital.

Although faulted for holding onto the interest-rate programs for too long, the Fed’s response to the market crash was as nimble as it gets.

In terms of fiscal policy, by the end of last year, Congress had committed to more than $4.5 trillion—or roughly 20%—of current gross domestic product, to address the crisis caused by the pandemic.

That was accompanied by a $1 trillion infrastructure boost to facilitate the modernization of the economy that will bolster wages, productivity and competitiveness over the long-term.

A needed reflation

Together, the actions by government have amounted to a monetary-policy success and the reflation of the real economy, even as public opinion has soured because of rising gasoline and food prices.

This was the policy mix that was shortchanged by the politics of 2012, following the financial crisis. In contrast to the drawn-out recovery from the Great Recession, direct aid during the pandemic maintained household balance sheets and spending and has also reduced poverty and hunger.

And the stimulus has arguably helped foster the best time for workers in generations. A historic labor churn coming from widespread resignations and the taking of new jobs continues to accelerate. Workers now have more employment choices compared to the lower job mobility and stagnant wages of the previous decade. This is particularly important for workers in low-wage and in-person jobs.

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The latest estimates by the Congressional Budget Office suggest that the economy has indeed made great progress in closing the output gap caused by the shock of the pandemic.

But the estimate for potential real GDP growth over the coming decade is for a decline in the rate of economic expansion from 2% to 1.7% per year.

That is because the pandemic cannot mask broader trends affecting the workforce, including rapidly changing demographics, lower returns on investment and a global savings glut that have caused interest rates to remain low. That suggests that concerns about an overheating economy, while a risk, may ease as supply chains normalize and the boost from both fiscal and monetary policy fades.

All things equal, and in the absence of high inflation, the decline in potential GDP would suggest a delay in stepping on the policy brakes.

If there were no health crisis, the increase in inflation would suggest stepping on the brakes with two feet. But that is not the case, and that is nature of the risks to the outlook as policymakers attempt to cool the economy without overdoing it.

With the dual shocks of the trade war and the pandemic still rippling through the economy, there’s no certainty that the impending changes in monetary and fiscal policy will be appropriate for either a burgeoning economy or one still dealing with the health crisis.

Risks to financial stability

About two years after the first coronavirus infections, central banks in developed economies are now moving beyond the extraordinary monetary accommodation.

They have started to normalize interest rates and re-establish acceptable levels of risk normally priced into financial assets. And perhaps more important, interest rate normalization will signify sufficient returns on the investment necessary to sustain the economic recovery.

But there are short- and long-term risks that might delay closing the output gap and prevent the economy from escaping the doldrums that have characterized most of the previous two decades.

We have lumped them into three sources of risk:

  • The immediate and long-term effects of the pandemic
  • Inflation and price instability that grew out of business and government decisions before the pandemic
  • The potential for policy errors growing out of the political consensus of the times

Risks to financial and economic stability

Risks of a continued pandemic

First and foremost, there is the pandemic, which continues to take a human and economic toll on workers, supply chains and hospitals.

We have no clear picture of when COVID-19 will no longer be a factor in the economy. While the omicron variant may have peaked, we cannot know what might happen in the future with other, potentially more deadly variants.

In the meantime, we will have to pay for the misallocation of resources caused by the pandemic. These might best be summarized by the long-term consequences of the increase in foregone health care. This happens when those unwilling to risk treatment at times of high transmission go without medical care. In financial terms, there is the pandemic’s strain on hospitals and their staff, with the excess costs ultimately borne by the public.

In terms of damage to the labor force, much of the worker shortage is a direct result of the pandemic, which has accelerated the exit of those 55 and older from the workforce. Of the 2.8 million workers that the economy is short compared to pre-pandemic levels, that cohort accounts for well over 70% of the shortfall in labor facing the economy

An analysis of labor data by the Federal Reserve Bank of Cleveland finds that the reasons for nonemployment have shifted from reduced demand (like business closings) to reduced supply.

Most nonemployment is now connected to three categories: being sick from COVID-19; child care and elder care responsibilities; and the residual “other reasons” category.

The analysis shows that the burden of these concerns fall mainly on Black and Hispanic women, while the burdens of “other reasons” appears to be associated with challenges faced by lower-income workers who are unlikely to overcome such problems quickly.

“The persistence of these answers and the characteristics of individuals’ providing these answers point to barriers” like child care standing in the way of employment rates returning the pre-pandemic levels, the report concludes.

We should note that the Bureau of Labor Statistics data represents concerns before this latest wave of coronavirus infections, which will most likely exert an impact on staffing in both the manufacturing and service sectors and on the willingness of consumers to patronize in-person services. A recent analysis found that 8.8 million workers have called in sick during the wave of omicron infections.

In terms of the supply chain, the spread of the virus continues to inflict damage both domestically and abroad.

Whether you’re a ski manufacturer in Colorado or a mom-and-pop surf shop in Southern California, raw materials and final goods are showing up late or not at all. In some cases, Halloween costumes shipped from Asia arrived just in time for Christmas.

Risks of unconstrained inflation

Second, there is the growing risk of unconstrained inflation amid higher interest rates. Price increases last year were a result of a surge in demand for goods meeting the lack of supply caused by pandemic shutdowns. This is demand-pull inflation at work, and interest rates are going to rise in its wake. The only question is how fast the Fed will increase rates.

Price increases last year were a result of a surge in demand for goods meeting the lack of supply caused by pandemic shutdowns.

In particular, we are concerned that as the price of capital increases, the pace of business formation may slow. That, in addition to rising business costs, may dampen what we think is an invaluable economic dynamic that provides jobs and innovation: business startups.

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Some costs were the inevitable result of the pandemic, like the cost of surgical gloves and masks. Another example is the lack of domestic production of computer chips which led to a diminished supply of new automobiles and the surge in demand for used cars.

The automobile industry was caught off guard as suppliers redirected chips to more profitable gaming and communications industries and did not have that properly hedged, resulting in disruptions to production that have not yet ended.

Those price increases quickly moved beyond used cars when production in the energy sector was unable to keep up with the reopening of the economy. Increases in the cost of energy spilled over into food and lumber, and the cost of heating buildings and homes.

Because of the continuing difficulties in restarting energy production and because of current geopolitical tensions, we can expect higher prices for energy to continue.

Potential damage to household balance sheets—which are the strongest in decades—has soured public opinion and imposes an asymmetrical impact across the income spectrum. But it’s a sliding scale with the harshest penalties falling on low-income households.

For instance, increases in prices for energy and food will have a dampening effect on total household spending, particularly as income assistance is eliminated.

Because personal consumption is the major determinant of gross domestic product, if inflation is not addressed, reduced household spending will over time hurt employment, wages and income, leading to further damage to household balance sheets.

That implies that there may be further need for income assistance along the lines of last year’s enhanced child tax credit, which economists consider the most efficient vehicle for delivering aid.

Risks of policy errors

Finally, there is the risk of policy errors.

Increasing short-term interest rates too quickly has the potential of stopping the economy in its tracks. Despite the rise in prices, expectations for inflation remain subdued. And to the extent that inflation is the result of expectations, that offers the Fed a degree of policy leeway beyond slamming on the brakes.

Of course, simply hoping that supply-chain issues will eventually work themselves out—and waiting too long to hike the federal funds rate—runs the risk of raising inflation expectations while inflicting damage on low-income households.

This episode of price increases most resembles the years immediately after the Second World War when, after years of privation, consumer demand was unleashed on a limited supply of goods. Yes, there was inflation, but it didn’t last forever. The inflation of the postwar years was part of the transition to consumerism and economic growth, aided by the GI Bill’s investment in the intellectual capital of the workforce.

The post-pandemic era will undoubtedly include inflation. But it will also include a significant infrastructure program that will enhance productivity and growth such that it can support normal increases in prices. We’ve gone through this before, most recently during the 1970s’ oil crisis, and the Fed knows how to kill inflation if it gets to that point.

The takeaway

To borrow a phrase, the pandemic has quickly laid bare the deficiencies of a less-competitive economy.

The country’s lack of investment in its infrastructure and workers since the 1950s and 1960s became apparent in the difficulty of transporting goods during the pandemic, and is now exacting a powerful toll.

The pandemic also laid bare what we might think of as the maturation of participation in the labor market. It took the shock of the pandemic for the labor force to reject the underpayment of low-skilled work after 40 years of a winner-take-all philosophy. The pause of the pandemic gave the labor force the time to assess the worth of traditional employment.

Though monetary policy plays a role in facilitating business investment and personal investment in intellectual capital, addressing those deficiencies will most likely rely on a fiscal response.

After all, raising the federal funds rate will not speed up the supply chain; but investing in roads and bridges and train tracks will. Drawing down the Fed’s balance sheet—and releasing the downward pressure on long-term bond yields—will not equip the labor force with the intellectual tools necessary to compete within a global marketplace. Investing in education and health care and nutrition will.

The United States is no longer the industrial engine of the world. For better or worse, it is a white-collar economy of abundance, surrounded by pockets of scarcity of opportunity.

If the U.S. economy is to avoid the underperformance of the last two decades, it needs to invest in the intellectual capital of its labor force, invest in research and development, and facilitate the investment in new-economy industries that will define the next generation.