By Terry W (Yr 13)
Introduction
The implementation of stringent policy measures by the governments to combat against the spread of the coronavirus to ensure public safety have caused global supply-chain bottlenecks. As a new variant has already been spreading and the unlikelihood that governments will loosen their restrictions anytime soon, these supply chain constraints may be prolonged as the firms cannot manage to match rising consumer demand, feeding into prolonged inflationary effects. These effects could be demonstrated through: the inflation monetarist model, whereby a lower worker productivity hold up supply chains, restoring the equilibrium price at a higher price level; drivers of current stagflation, such as change in working environments and workers’ working attitudes demonstrate the current inflation upturn; lastly, evaluation of the government responses in the context of 1970s experience help explain governments’ policies in dealing with inflation and demonstrate why current inflation is not transitory.
Omicron has caused disruptions to the business cycle as it is creating widespread social and political impacts that we experienced when Covid measures were first strictly implemented in the first quarter of 2020 – when unemployment rate rose rapidly. As the global population continues to grow and consumers are demanding even more technological goods, the aggregate demand could possibly outpace the supply of these products, causing prices to rise and driving a demand-pull inflation upturn. The continuance spread of the Omicron virus could wreak unprecedented structural changes, forcing inflation outside of the business cycle. “I think it’s probably a good time to retire that [transitory] word and try to explain more clearly what we mean”, said Fed Chairman Jerome Powell. Inflation driven by supply chain disruptions along with rapid increases in demand have already caused food prices to rise over 5.3% last year and energy by about 30% (Leonhardt, 2021). Goldman Sachs analysts forecast that inflation will unlikely return to Fed’s long-term inflation target about 2% not until the last quarter of 2022. If inflation is transitory, inflationary pressures would have improved as it follows the business cycle, but this is clearly not the case. As the economy continues to expand and factors of production are becoming scarce, inflationary pressures could be a major problem, as Fed Chairman Jerome Powell says, “factors pushing inflation will well linger into next year” (Leonhardt, 2021). If elevated inflation continues to sustain beyond the pandemic pressures that are backing up the supply chain and that unemployment rate is due to worsen, stagflation may result.
Inflation Models
According to the monetarist model, an increase in aggregate demand from AD1 to AD2 increases the general price level from PL1 to PL2, extending aggregate supply along the SRAS1 curve, and thereby creating a temporary inflationary gap. As a result, it temporarily increases the national output beyond its current capacity and raises the cost of factors of production. This will eventually cause aggregate supply to shift from SRAS1 to SRAS2, restoring the macroeconomic equilibrium at the full employment level of national output (Yf) but at a higher price level. However, the monetarist model expects the inflationary gap to reduce in the future as the economy undergoes a recession when entering a new stage in the economic cycle, and hence, inflation becomes transitory. However, what the current economy is experiencing does not follow the monetarist theory, instead, the supply chain issues are being overstressed by consumers because of the ongoing coronavirus, which causes a shift in the long-run aggregate supply curve (LRAS1 to LRAS2), as indicated in figure 2. Because there is decreasing LRAS and increased factors of production, the economy may be positioned in a stagflation at the equilibrium (PL3Y2).
Drivers of stagflation:
The LRAS has shifted to the left due to supply shocks, such as fertilizer shortages going about. This meant that fewer of the agricultural products would be available at the same price, creating a hold-up in farming industries as this causes structural changes, if the pandemic continues; hence, SRAS1 shifts to SRAS2 on the left. Other than supply-chain issues, strict coronavirus policies from various countries at the beginning of 2020 pushed many workers into unemployment, peaking at about 14.8% in the U.S. (Falk, 2021). As a result of unprecedented change to the labour force, labour force in the U.S. is much smaller than it was before the pandemic. But as the economy seeks to recover, demand for labour is growing for unskilled jobs, however their unwillingness to go back to work could lead to increased wage demands. Gus Faucher, PNC’s chief economist, said, “These higher labour costs will add to broad inflationary pressures in 2022”. Wage rates and salaries had risen by 1.5 percent and benefits cost by 0.9 percent from June through September (Miller, 2021). As more people are exiting out of the workforce along with increased costs of factors of production (SRAS1 to SRAS2), a shift of LRAS1 to LRAS2 could cause a prolonged inflationary gap that would not be corrected by the business cycle since stagflation is not demonstrated in the business cycle and the monetarist model cannot self-correct stagflation. Hence, inflation is not transitory.
Increased demand for labour is not the sole cause for increased labour costs; drastic changes in workers’ working attitudes driven by the pandemic, with 71% (compared to 21% pre-COVID time) of the workers working from home in 2020 (Parker, et al., 2021), is why consumer demand for technological products have been increasing over these two years. Abrupt closure of many workplaces in the first quarter of 2020 ushered the beginning of large-scale remote working, due to strict coronavirus restrictions placed by the governments of many countries. As workers struggled to get used to their new working environment and conditions, productivity rate fell and may continue to fall if the Omicron virus prevails. A lower productivity rate and a smaller working force amongst the firms ultimately lead to lower economic output from the markets; the PPC graph now shifts inwards, as the cost spent on resources and manufacturing processes are no longer maximized. However, this could be further worsened if unemployment remains high and that the current productivity rate continues to stay at the same level. Current unemployment level is not driven by a recession part of the business cycle, but by firms wanting to shed labour, changing the availability of labour as a factor and shifting LRAS inward, and people’s willingness to exit out of the labour force. Because of this, a lower economic output along with high unemployment rate are not only stunting economic growth through supply chain issues, but also creating a prolonged stagflation which could shrink the global economy through decreasing the purchasing power of consumers. These labour changes are unlikely to be adjusted in this short term and act as driving factors for stagflation effects.
Government Responses
Amid the pandemic, governments are nevertheless aiming to reduce the current inflation rate, or at least, cap it through different policy measures. In combatting the onset of a swift recession in the first quarter of 2020, the Federal Reserve ramped up its quantitative easing, whereby the central bank buys governmental bonds from the Fed to help increase the country’s money supply, and reduced inflation rates to promote spending in the economy. As of March 2020, Fed’s policy-setting “tapered” asset purchases by $15 billion each month and the Central Bank has been purchasing $120 billion of Treasury bonds and mortgage-backed securities to fight the effects of the COVID-19 pandemic (Wemy, 2021). Furthermore, the Fed also implemented open market strategies to help bolster the economy; they cut the target federal fund to under 0.25%, which lowered the cost of borrowing on mortgages, promoting consumer spending. Nonetheless, shoring up the economy caused inflation to rise, hitting double digits for both energy and auto sectors this month. In fear of seeing the inflation rate continue to rise, the Fed said that it will now reduce quantitative easing. For instance, it will reduce purchasing the Treasury bonds by $10 billion a month from $80 billion in October and mortgage-backed securities by $5 billion from $40 billion (Parker, et al., 2021). However, if the Fed’s drawdown continues at this pace, the Fed will only stop buying new assets by 2022, meaning that inflation would be prolonged and may not improve until then.
In addition, if monetary policies, are solely used to mitigate the stagflation effects, it may not be merely enough to help reduce inflation, let alone, drive economic output. This is because of the built-in expectations that consumers might have caused from the long-lasting changes implemented due to the pandemic. As working from home becomes a cultural norm – workers don’t return to office work even after coronavirus restriction have subdued – productivity rate may remain at the current level. More than half of employed adults (54%) in the U.S. who say that their job responsibilities can mostly be done at home would want to carry on working in the same working conditions even when the pandemic is over (Parker, et al., 2021). As a result, the implementation of monetary policies may fail to promote increased economic output, due to labour constraints, which means that technological suppliers may struggle to meet the high demand from consumers. Hence, the government may struggle to cap inflation rate. Because of that, the Fed could ease supply chain issues through drafting supply-side policies, which could help promote both increased productivity and increased efficiency (shifting LRAS to the right). However, even if the effects of supply-side policies could help promote economic output, they are not a ‘magic bullet’ and the debate of selecting the right policies may delay their effects – taking several quarters to quell inflation rate. Furthermore, if the unemployment rate continues to sustain at the current level with coronavirus restrictions still emplaced, the
Biden administration may continue to issue even more stimulus packages, making inflation rate even harder to control. For instance, Biden’s administration passed a Build Back Better Act in 2021, which helped fund health care, children’s education, and bring down costs to help strengthen the middle class.
Previous Experiences of Stagflation
The stagflation effects that the economy is currently experiencing may mirror those in the 1970s. Along with soaring oil prices and a higher CPI index, unemployment rate was high, peaking to about 6.0% in 1979, and the economy was also going through a severe recession. The prevailing belief of this has been that high levels of inflation were the result of an oil supply bottleneck, causing an increase in the price of gasoline, which fed into the higher factors of production costs when laborers asked for higher pay rises. In the hopes of not reducing its profit margins, firms raised the prices of their products. The cost-push inflation did not align with Keynesian economic theory – stated that unemployment and inflation had inverse relationships with each other – and the business cycle, which is similar to the surge in the current inflation. The Federal Reserve, however, failed to foresee this: they did not have a mandate to raise interest rates and slow down the economy until Paul Volcker was appointed as Federal Reserve Chair in 1979.
Relentlessly working to quickly ease the detrimental effects of inflationary pressures, Paul Volcker – the Fed Reserve chairman at that time – implemented monetary policies to help slow the economy’s growth and therefore shrink inflation. This raised the Fed’s benchmark interest rate up by two-fold (from 11% to 20%) (Hutton, 2019). Although this may have achieved Congress’s intended effect of reduced economic growth and a significant fall in inflation rate (from 14.85 to 3%), it pushed the national economy into a two-year recession from 1980 to 1982, with unemployment rate rising above 10% (Hutton, 2019). Moreover, the effects of the monetary policies elicited the strongest political attacks and most widespread protest in the history of Federal Reserve. And now, there has been pressure for Powell to pull a Volcker to help fight the rising prices. The Fed, however, is nowhere close to full employment at this stage, which is necessary alongside stable prices. Budget deficit and current government debt may also limit government’s willingness to raise interest rates since a raise would also increase the cost of government’s debt. Furthermore, the economy is undergoing a different circumstance than those experienced in the 80s. With the pandemic lasting for nearly 2 years and not likely to go away anytime soon and unemployment rate above Fed’s target, Biden’s administration and Powell’s team may be reluctant to replicate what Volcker did at the expense of a recession. Increased globalization along with technological driven shifts in work patterns and employment have led to different drivers of stagflation which was based on rising energy prices in the 1970s. “Pulling a Volcker might mean having the confidence to see through pandemic-driven, elevated CPI numbers until the job is done getting people back to work” (Weisenthal, 2021).
The unprecedented changes to the labour force in tandem with rising aggregate demand for clothes, food, and technologies have caused inflation to rise and hard to predict in the future, as demonstrated in the monetarist model. Structural changes to land and labour have resulted in a disequilibrium between consumers and producers, making prices higher than before. In response to this, The Fed intervened with arrays of actions and policies to help keep credit flowing to limit the economic damage from the pandemic, preventing financial market disruptions from intensifying the economic damage. Experiences of stagflation in the 1970s suggest that short-term policies are not likely to address rising inflation driven by stagflation effects, causing the Fed to try out different monetary and fiscal policies, such as open market systems – through tapering its pace of asset purchases – and quantitative easing – through purchasing large amounts of debt securities. These policies may fail to succeed if built-in expectations of inflation have been consolidated from Omicron’s spread, making it harder and longer for the government to use policies to alleviate these inflation pressures. If supply-chain issues continue to last, inflation may be no longer “transitory” but perpetual in the coming quarters and may well prolong into 2023.
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