By Skanda Amarnath and Arnab Datta
Inflation has become a major political issue. Today’s price increases are being used to undercut the case for more federal spending, especially on necessary climate and housing investments. Polling demonstrates that rising costs of living, particularly rising medical costs, are the greatest concern for voters today. Should measured inflation continue or expand beyond the current set of transitory shocks—it could be used to justify policy responses antithetical to the goals of economic growth and full employment.
Policymakers outside of the Fed can get ahead of this scenario by proactively adopting an “inflation management” approach that better achieves its policy goals. This does not have to mean Nixonian price controls. It means that the White House and Congress should, where feasible, use targeted fiscal policies and structural reforms to equitably address the demand- and supply-side challenges that contribute to inflationary pressure.
Healthcare as a sector is unique in terms of the influence that the federal government can exert over inflationary dynamics through legislation and regulation. It also makes up about a quarter of the Fed’s preferred real-time gauge of forward-looking inflationary pressures--”core PCE.” Rent inflation is likely to contribute more substantially to inflation readings in 2022 (0.4% additional contribution according to our forecasts), but those effects can also be entirely offset with healthcare policies that current law and proposed rulemaking already favors.
Some healthcare policy interventions outlined in the research report published last week could provide substantial disinflationary pressure on 2022 core PCE and in the years ahead. By adjusting Medicare reimbursement rates, and achieving prescription drug pricing reform through aggressive Medicare negotiation, policymakers could achieve substantial disinflationary effects without the demand destruction that rate hikes produce. Given the salience of inflation for policymakers, lawmakers, and everyday Americans, disinflationary healthcare policies should be a key priority for Congress and the Biden Administration alike.
While the Fed is theoretically capable of controlling inflation unilaterally, relying on interest rate policy alone for disinflationary pressures risks abandoning policymakers’ goals of high employment and strong economic growth. Congress and the executive branch have tools available to achieve equitable and targeted disinflationary outcomes without the recessionary risks posed by blunt use of interest rate policy.
An open-ended “inflation management” approach is the appropriate response to the remarkably uncertain nature of the pandemic recovery. The economy cannot reorganize itself overnight. Lockdowns, supply chain disruptions, and the pivot to work-from-home have created whiplash changes in consumer demand that are still driving idiosyncratic price spikes. One helpful lens for understanding today’s situation is the end of World War II: consumer demand spiked alongside the end of price controls and rationing drove inflation above 5%. It took two years to reorient the war economy around the needs of domestic and global supply chains, but the inflationary episode ended without the kind of monetary tightening we saw in the 1970s and 1980s. Inflation behaved similarly in the early 1950s as well, as we wrote about last month. We may see those dynamics now as supply chains are restructured to accommodate a post-pandemic economy, on a timeline determined by whatever pandemic-driven uncertainty still remains.
Many components of the Infrastructure Investment and Jobs Act and the Build Back Better Act should have long-term disinflationary impacts, but they will take time to pay off in the form of lower prices. It may take years to see the full impact of actions taken to alleviate the global semiconductor shortage or investments in transportation infrastructure.
An “inflation management” approach should be oriented around two goals: (1) addressing rising costs in areas that people feel day-to-day (2) reducing the pressure on the Federal Reserve to raise interest rates prematurely, thereby curtailing the recovery before sustainably achieving sufficient rates of wage growth and employment.
Higher inflation readings naturally raise concerns about whether everyday Americans are actually getting ahead in terms of “real” wages. Wage growth and price baskets vary substantially across Americans and through time. While measured inflation has largely been due to extreme price shifts in supply-constrained sectors like housing and automobiles, most families are not buying a car or house every month, or even every year. However, these families do regularly purchase prescription drugs and medical care, sectors where policymakers can directly push for disinflationary outcomes. Reducing inflation where possible would simultaneously take pressure off the Federal Reserve and some reforms can create tangible cost savings for families.
Volatility linked to the pandemic, reopening, and bumps in global supply chains has already lifted inflation readings. The Fed’s preferred inflation gauge (“core PCE”)—which excludes traditionally volatile food and energy prices—has risen to 3.6% year-over-year as of August 2021. This is 1.6% above the Fed’s desired 2% inflation target.
While these pressures should mostly dissipate over the next 12 months, the appearance of additional inflationary impulses over the coming quarters—even if idiosyncratic and transitory—will increase pressure on the Federal Reserve to raise rates sooner and faster. More persistent sources of inflation, namely rent and owners’ equivalent rent (OER), are also likely to be a more meaningful contributor to inflation in 2022, easily capable of contributing an additional 0.4% to core PCE readings. But solving challenges like pandemic-related bottlenecks and the systematic shortage of housing ideally need to happen through more supply-side investment. Hiking interest rates doesn’t just ration demand in this context. It also risks stifling investment, weakening the employment recovery, and undercutting economic growth.
As it stands, elevated inflation readings are already creating pressure on the Fed to raise interest rates. Some FOMC members have signaled a need to hike rates before the labor market even returns to what was considered maximum employment prior to the pandemic. Tighter financial conditions will slow economic growth and employment gains coming out of the pandemic. This has been the strongest recovery from a recession in a generation, and policymakers should do everything they can to ensure it continues that way.
A unique quirk of the pandemic recovery is the fact that inflation is largely occurring in capacity-constrained sectors. Low rates can help support the kinds of investments in capacity those sectors need in order to prevent inflation and raise standards of living over the longer run. By using the tools outlined below to slow the growth of prices in the aggregate without slowing down the economy, the administration can buy time for different industries to invest in capacity before the Fed is forced to raise rates. A better future—one with abundant clean energy, revitalized American manufacturing, higher worker productivity and pay, and more affordable housing—requires substantial investment across the board. Inflation might seem the most salient near-term risk, but the greater threat over the long-term would be the Fed choking off a potential once-in-a-generation investment boom in all of these critical sectors.
Despite some obstacles, the policy interventions recommended by an inflation-management mindset are within political reach. They offer an equitable approach that is strictly superior to interest rate hikes in managing the tradeoffs between growth and inflation. Healthcare policy is only one of many possibilities, but it is the most salient today given the path the infrastructure and reconciliation bills have taken. To learn more about the parameters and mechanisms of these policies, the details can be found here.
