The economic trends that will create post-pandemic policy challenges

The Biden administration’s science-based approach to tackling the pandemic, along with its emphasis on better federal coordination of nationwide vaccine efforts, has now made it possible to consider an early attainment of herd immunity in the U.S. against COVID-19. From an economic standpoint, this raises the possibility that the U.S. will experience an unusually rapid economic recovery in the second half of 2021. Rapid economic growth along with recent changes in fundamental macroeconomic policy precepts may finally awaken long dormant inflation and pose a challenge to policymakers, investors and financial markets.

The enormous fiscal stimulus measures enacted in 2020 and the limited spending opportunities created by pandemic-related shutdowns have led to a massive surge in household savings. (It is worth noting that the biggest savers appear to be the richest households.) Further fiscal transfer could bolster household balance sheets even more and unleash pent-up demand when much of the domestic economy is able to fully reopen this summer. The size of the consumer spending binge will depend on how rapidly and to what extent the projected $2.4 trillion in excess savings will be deployed.

On the monetary front, through its large-scale asset purchase programs, the Federal Reserve has been creating new reserves to purchase vast quantities of Treasury securities and other assets since spring 2020. The historic level of liquidity injection and money creation by the Federal Reserve has caused the money supply (as measured by the stock of M2) to surge by over 25 percent over the past year. The decline in the velocity of money (that is, the turnover of money) has so far kept a lid on inflation. There is a distinct possibility that the velocity of money will spike in the second half of this year as transactions volume surge. 

Several factors complicate the real-world relationship between money supply and inflation. Even Milton Friedman acknowledged that there were long and variable lags in the response of inflation to changes in money supply. In addition to its role as a medium of exchange, money also acts as a store of value. (Money’s attractiveness as a form of wealth relative to other assets is often determined by a basic trade-off — money is the most liquid form of asset, but it suffers from the fact that most forms of money provide little or no nominal yield.)

The inherent uncertainty associated with the demand for money can be characterized more broadly by contrasting the transactions motive with the precautionary motive for holding money. The velocity of money will be higher when the transactions motive is dominant. On the other hand, money turnover will be lower when the precautionary motive is driving money demand (as it did during the early stages of the pandemic). Furthermore, when interest rates are very low or near-zero on safe non-monetary alternatives like government bonds, the opportunity cost of holding money declines sharply. The contrasting motives for holding money and the resultant difficulty associated with estimating the demand for money complicate the relationship between money supply and inflation.

Economists have also noted the existence of threshold effects when considering the relationship between money supply and inflation. At low levels of inflation, the link between changes in money supply and inflation is somewhat tenuous. The link, however, becomes more apparent at high levels of inflation. 

Should we expect a possible spike in inflation rates in the coming quarters? There is a distinct possibility that as the pandemic-driven precautionary surge in cash holdings and bank account balances gives way to a post-pandemic increase in transactions (driven by a spike in consumer spending), the velocity of money will recover rapidly. Given the Federal Reserve’s current policy stance, a tightening of monetary policy may be delayed until late 2022 or early 2023. Consequently, the possibility of higher-than-expected inflation should not be underestimated.

Whether the jump in inflation can be sustained will depend on future inflation expectations and on fundamental structural forces (such as globalization, demographics and technological changes). What may be less relevant is the traditional Phillips curve-based link between unemployment and inflation. In fact, the pandemic shock has sped up underlying technological trends that are likely to create significant labor market dislocations and further reduce the relevance of the Phillips curve. 

Long-term labor market challenges cannot be addressed by temporarily overheating the economy. We need to rethink our basic approach to worker training and provide direct support to those willing to undertake skill retraining/upgrading (there is currently a large-scale shortage of skilled tradespeople in the U.S. that is not being addressed). Policies aimed at encouraging every high school graduate to attend four-year colleges, regardless of their personal preferences/interests or academic preparedness, will prove to be counterproductive and lead to both grade and degree inflation. Creating German-style apprenticeship programs may offer a valuable alternative track for high school graduates.

Recent experience has shown that effective fiscal policy truly matters as the downside risks associated with overreliance on monetary policy become apparent. As we near the end of the pandemic nightmare, it is necessary to reorient fiscal policy towards longer-term priorities. For instance, improved automatic stabilizers combined with increased funding for worker retraining and infrastructure upgrades are likely to both cushion vulnerable segments of the population from exogenous shocks as well as prepare the U.S. economy to deal with 21st century challenges. 

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa