What’s Next For Fiscal And Monetary Policy?

The COVID-19 pandemic has had significant impact on our domestic economy. It comes as no surprise that the ongoing pandemic will continue to influence our economic policies for years to come. The challenge lies, however, in predicting what this will look like and what the long-term ramifications will be.

At the start of the pandemic, I joined some of Princeton University’s brightest economic and health policy minds to attempt just this: to predict how a global pandemic would affect our country’s fiscal and monetary policy. It’s safe to say that in April 2020 when we first came together, we had no idea what our fight against COVID-19 would entail, nor would we have predicted we would be participating in our 5^th iteration of this discussion just a couple weeks ago.

I recently sat down with Drs. Jessica Metcalf, Alan Blinder, and Bill Dudley to, once again, try and predict the future of our economy, to analyze how Omicron and future variants will impact our projected outlook, and to examine how our initial pandemic fiscal and monetary policy panned out.

Current State of the Virus:

To understand our current economic outlook, we started by laying out the current state of the virus itself. The latest variant, Omicron, has resulted in a “gigantically” larger number of positive cases than we saw during our last major peak. Fortunately, though, Omicron results in lower severity of symptoms, and case rates are beginning to stabilize.

“Even if the infection were half as severe, if it’s twice as transmissible it will yield the same pressure on the health system.”

Regardless, Omicron should still have us concerned. This variant has placed critical stress on our healthcare system which is overworked and understaffed. Dr. Metcalf, Associate Professor of Ecology, Evolutionary Biology & Public Affairs who specializes in disease modeling at Princeton, explained that “even if the infection were half as severe, if it’s twice as transmissible it will yield the same pressure on the health system.” She added that while the death rate has been considerably lower than we saw with the Delta wave, the number of total deaths, however, is already higher.

In analyzing how Omicron is affecting our economic outlook, we turned the discussion over to renowned economists Alan Blinder, the Gordon S. Rentschler Memorial Professor of Economics and Public Affairs, and a former Vice Chairman of the Board of Governors of the Federal Reserve System, and Bill Dudley, former president of the Federal Reserve Bank of New York and now Senior Research Scholar at the Griswold Center for Economic Policy Studies.

For the most part, Blinder and Dudley agreed that our economy has powered through this most recent spike in cases. When Blinder presented a graph of our country’s GDP, it was impossible to pinpoint when the Omicron wave started, which has not been the case with past variants. Though Omicron has been a bump in the road, our economy has continued to rebound largely due to vaccines and boosters, as well as COVID-19 fatigue.

Blinder stated, “…a lot of people have the attitude ‘enough is enough,’” highlighting the combined impact of people refusing to go on lock down with the resiliency and adaptability of the private sector in the changing of business models.

Similarly, Dudley felt that though the new variant has been shown to be less virulent, a more important factor is that for every degree of risk, our degree of disruption (economically as well as in terms of social distancing) is now much less.

Did Early Fiscal Expansion Packages Work?

During the early days of the COVID-19 pandemic, fiscal expansion packages were enormous, with the federal government granting $5 trillion worth of stimulus.

The first relief package came in March 2020 with the $2.25 trillion CARES Act. Next, Congress passed the $0.9 trillion Consolidated Appropriations Act in December 2020 right at the end of the Trump administration. Lastly, President Biden signed the $1.9 trillion American Rescue Plan in March 2021.

For the most part, initial stimulus, specifically with the CARES Act, was bipartisan and well received. And though these relief packages were certainly flawed, they served as lifelines for many families across the country and prevented a much worse economic outcome. On the whole, Blinder noted that in our moment of crisis, Congress acted fast and at large scale. He also observed that “all this actual and projected public debt has not driven up long-term interest rates at all.”

Dudley was more critical of our early relief packages. He agreed our initial fiscal response was strong; however, he felt that there was also a significant downside due to the fact that many stimulus-related benefits accrued unevenly with high income households disproportionately being aided.

Blinder also pointed to the poor rollout, oversight, and targeting of the Paycheck Protection Plan, loan forgiveness, and the stimulus “checks” many Americans received across the country to help families during unprecedented difficult times. For those low-income Americans not on the IRS tax rolls, checks may never have made it to them.

Further, stimulus packages and changed consumer behavior—both due to the stimulus itself as well as to pandemic fears—have resulted in supply chain shortages as our demand for goods has skyrocketed. This shift has also been a key component of our exceedingly high inflation rate.

Should we be concerned about inflation?

The most pressing issue—or non-issue—today is inflation. On this topic, Blinder and Dudley had slightly different viewpoints.

Blinder firmly situates himself on “Team Transitory.” Though inflation is too high—relying on the core personal-consumption expenditures report of 4.7% rather than the consumer-price index value of 6.8% is more meaningful—he does not think inflation is here to stay.

“This is a new phenomenon: we have not had high inflation for years, we’ve had high inflation for months.”

Why? In short, Blinder points to the “inflationary price” he feels we must pay for our shift in consumer spending habits away from services and toward goods—where supply chains were not prepared to handle the loads. He sees this already starting to return to normal as COVID-fears subside.  As evidence he cited the fact that inflation has remained fairly concentrated in a subset of the goods and services that comprise the index, that energy prices are coming down, that fiscal and monetary stimulus are rightly and quickly disappearing, and that bottlenecks and shortages have already begun to dissipate.

He reminded us that “this is a new phenomenon: we have not had high inflation for years, we’ve had high inflation for months.” Naturally, over the course of a year or two (rather than months), Blinder believes inflation will return close to the Fed’s targeted 2%.

Dudley, on the other hand, is slightly more critical of the Fed and feels that their need to intervene has only been delayed rather than avoided. He warns that “how financial conditions respond to what the Fed does will ultimately drive how far the Federal Reserve has to go during this business cycle.” Current inflation projections, he feels, are too optimistic and actual inflation will be higher and last for longer than we currently anticipate.

“The Fed stayed too easy, too long.”

Dudley describes “four major errors” he believes the Fed has made: first, the Fed operationalized their average inflation targeting regime in a way that means that monetary policy will be extraordinarily easy even after the economy has reached full employment. Second, they were too worried about generating a “bond market taper tantrum” like the sell-off that happened in 2013, which has slowed down tapering of asset purchases. Third, the inflation shock has turned out to be not entirely transitory, a risk he doesn’t believe they anticipated. And fourth, the labor market tightened much faster than the Federal Reserve expected.

Dudley substantiates his projections by pointing out that the labor market is already exceptionally tight—the unemployment rate is well below the estimated level of full employment and the labor force participation rate is recovering slowly due to retirement and health concerns. “If you look at the ratio of unfilled jobs to the number of people that are unemployed, this is an all-time record,” Dudley observed. These patterns persist despite increased wage incentives.

Unemployment is unsustainably low and wage incentives are already above what they would be at the Fed’s goal of 2% inflation. Dudley warns that any further increase would likely have a direct impact on our monetary policy.

From his perspective, inflation is here to stay because “the Fed stayed too easy, too long.” In being late, Dudley predicts the “bottom line is … the Fed is going to have to move to a tight monetary policy rather than a neutral monetary policy.”

In sum, over the last two years we have undergone a tremendous amount of economic change: a stock market boom, climbing inflation, disruptive worker shortages and “The Great Resignation,” and trillions of dollars’ worth of federal stimulus infusing the economy.

Understandably, while we are still learning how to effectively and safely manage a world with COVID-19, it has been difficult to predict what lies on the economic horizon.

All of these combined forces will eventually determine our fiscal and monetary policy moving forward and what the Federal Reserve response will be. And though the future remains impossible to predict, these three bright scholars provide sound reason and guidance for our fiscal, monetary, and health policy as we move into the new year.

You can listen to the full discussion on Episode 162 of A Second Opinion podcast.