With the midterm elections two weeks away, polls show that inflation looms as the top issue on voters’ minds. Indeed, it is the biggest obstacle Democrats face to retaining control of both houses of Congress.
President Biden has tried to deflect this by citing the Inflation Reduction Act of 2022 as a way to address the problem. This legislation is popular with the Democratic base because it contains measures to lower drug prices and authorizes nearly $400 billion in spending to address climate change. Yet, it is unlikely to sway most voters for a simple reason: The effects will not be evident for a long time and inflation currently stands at a four-decade high.
How then should voters assess Biden’s responsibility for inflation?
The public should understand that the main causes of inflation today are overly accommodative monetary and fiscal policies and supply shortages in the wake of the COVID-19 pandemic. While the president is accountable for setting fiscal policy, he can influence monetary policy only indirectly by appointing the governors of the Federal Reserve System, including the chair.
Since the Federal Reserve was established in 1914, the most common way presidents have tried to influence monetary policy is by jawboning the Fed to refrain from raising interest rates in election years. The most blatant attempts were by Presidents Lyndon Johnson and Richard Nixon in the period from the mid-1960s to the early 1970s, when inflation accelerated markedly. By comparison, President Reagan did not interfere with Fed policy in the early 1980s even though interest rates soared to record highs during Paul Volcker’s tenure as chair.
During the period of disinflation that ensued since the early 1990s, most U.S. presidents have allowed the Fed to act independently. The outlier was Donald Trump, who called the Fed members “boneheads” in 2019 for not lowering interest rates below zero as the European Central Bank did: “It is only the naivete of Jay Powell and the Federal Reserve that doesn’t allow us to do what other countries are already doing,” he said.
By comparison, Biden has taken a hands-off stance in dealing with the Fed. When Biden reappointed Powell as Fed chair last November, I wrote that he should privately signal to the Fed that it would be okay to raise rates with inflation emerging as a problem. But it is hard to criticize him considering no other U.S. president did this.
The main area where Biden has faced criticism relates to outsized government spending. The $2 trillion American Rescue Plan, in particular, has come under scrutiny by economists for contributing to the surge in inflation.
When the legislation was passed in March 2021, the economy was well on the path to recovery from the pandemic, with the unemployment rate having dropped to 6 percent from a peak of nearly 15 percent. The main provisions included extending increased unemployment benefits for six months and providing payments to individuals of $1,400 each that were in addition to payments of $600 enacted in December. The results of this cash infusion were readily apparent: Real GDP expanded by 5.7 percent in 2021, while core goods inflation surged from 2 percent to more than 10 percent by year’s end.
As reported by David J. Lynch of The Washington Post, several economic studies conclude that as much as 3-4 percentage points of the recent increase in inflation is attributable to the legislation. But determining the plan’s impact on inflation is difficult to measure precisely because it hard to separate the effects of monetary policy and supply chain disruptions. Consequently, some studies show much smaller effects of the relief package on inflation.
By comparison, there is general agreement that the package speeded the recovery and contributed to record low unemployment. This raises another issue: Namely, why is the U.S. electorate quick to blame Biden for inflation but not give him credit for the economic recovery and low unemployment?
One possibility is that the electorate mainly cares about unemployment when it is high and there is a recession. Otherwise, when jobs are plentiful, as they are today, inflation becomes the over-riding issue because it acts as a hidden tax on people’s incomes.
Another possibility is that people look at both metrics – the unemployment rate and the inflation rate – and combine them to obtain what economist Arthur Okun called the “misery index.” Okun developed the concept in the 1970s, when inflation and unemployment were both unusually high. The index peaked during Jimmy Carter’s presidency, when it reached an average of more than 16 percent, and it subsequently declined to about half that level from the mid-1980s to the onset of the Global Financial Crisis (GFC) in 2007-2008.
The challenge President Biden faces is that the index currently stands at about 12 percent due to high inflation. It could climb further if the economy were to slip into recession and boost unemployment. Meanwhile, the big unknown is how much further interest rates will have to climb to bring inflation down closer to the Fed’s 2 percent average annual target.
If Biden seeks reelection in 2024, he will need to answer a key question on voters’ minds — namely, are you better off today than you were four years ago? Biden will likely maintain that he acted boldly in boosting government spending during the pandemic because the response to the GFC produced an anemic recovery.
However, the current situation is a very different type of shock. Because the financial system was not impaired by the pandemic, there was a quick recovery. When combined with the energy squeeze by Russia, the result is that fiscal and monetary policies have had a much greater impact on inflation today. This also means policymakers now have less latitude to combat an economic downturn.
Nicholas Sargen, Ph.D., is an economic consultant to Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books, including “Global Shocks: An Investment Guide for Turbulent Markets.”