The Bureau of Economic Analysis (BEA) just released the first estimate for real GDP growth for the fourth quarter of last year. The economy grew at a 6.9% rate. For the entire year, growth was slightly better than expected, at 5.7%. As was reported earlier this month, the Consumer Price Index (CPI) increased by 7%.
Last year was a high growth and high inflation year. The year also ended at a full-employment level. In fact, there was a labor shortage, which hindered growth. Today the economy is producing about 2% more goods and services than was being produced before the pandemic.
The country is producing at that level with about 3 million fewer workers. Had those 3 million decided to return to work, growth would have been even higher.
This Is Called an Overheated Economy
Economists refer to an economy with record high growth and record high inflation as an overheated economy.
With an overheated economy, it is critical that actions are taken immediately to cool the economy. Failure to do so will lead to stubbornly high and stubbornly persistent inflation. That must be avoided and should be the primary focus of government policy today.
To cool an economy, the federal government should reduce spending. In the last two years, the federal government has spent $13.6 trillion which was $5.7 trillion more than was received in tax revenue. That contributed significantly to the excess demand in the economy which led to the high inflation.
Government spending should be reduced, or at least delayed until inflation comes down. Obviously, that means that no new spending should be considered. The Biden Build Back Better plan should not be passed. That would increase government spending, add more excess demand and lead to even higher prices.
The Federal Reserve (Fed) should also act quickly. The reality is that the Fed is taking too little action — and the action is too late. Early last year, it was obvious that inflation would be a serious problem. The Consumer Price Index (CPI), which typically increases by about 0.2% monthly, increased 0.3% in January, 0.4% in February, 0.6% in March and 0.8% in April.
A Fed That Ignored Inflation
Instead of acting, the Fed did nothing, saying that the inflation was transitory and would fall as soon as the supply chain disruptions were resolved. In October, when the third-quarter gross domestic product (GDP) number indicated that the economy was producing at a higher level than before the pandemic, it was obvious the inflation was not primarily caused by supply chain disruptions.
In November when the inflation rate hit 6.8%, the Fed decided to begin to reduce its bond-buying program. That will slow the growth of the money supply and reduce some demand. In December, the inflation rate continued to rise, so the Fed decided to speed up the end of bond-buying.
Just recently, the Fed said that the bond-buying program will end in March, and at that time, it will begin to raise interest rates. “The committee is of a mind to raise the federal funds rate at the March meeting assuming that the conditions are appropriate for doing so,” Federal Reserve Chairman Jerome Powell said.
He also said that if inflation “has not gotten better. It has probably gotten a bit worse … To the extent that situation deteriorates further, our policy will have to reflect that.”
Inflation Will Worsen in ’22
Finally, it appears, the Fed will put the reduction of inflation as its primary policy goal. This year, because we will see more energy inflation, more wage inflation and more government deficit spending, inflation will worsen. We also note that the producer price index increased by nearly 10% at the end of last year.
Since economic growth is very strong and the economy is operating at full employment, price stability should be the top priority for government policy. The Biden Administration will not reduce or even delay spending — so it’s up to the Fed.
Fed officials need to act quickly. The longer they wait, the more drastic their action will be.