Inflation is the “number-one challenge facing families” and “my top domestic priority,” said President Joe Biden in remarks at the White House yesterday. The Consumer Price Index has risen 8.5 percent over the past year, and in recent Gallup polls almost one in five Americans identified it as the biggest problem facing the country overall. No longer do pundits entertain the notion that inflation harms only the wealthy and redistributes nicely to lower-income groups.
What then can the Biden administration do about the situation?
While debate over precisely why inflation is so high is heated and ongoing, there is little disagreement that fiscal and monetary policy have combined over the course of the past two years to raise aggregate demand above aggregate supply. This in turn has led to rapid price increases. Other generally agreed upon contributing factors include the continuing COVID-related supply-chain problems and increases in commodity prices due to the war in Ukraine, both mentioned by Biden yesterday. For present purposes, however, what matters is not assigning blame but charting a course forward. The least painful path is to pursue policies that will expand aggregate supply.
There are three components to the policy response to this situation: monetary policy, which is orchestrated by the Federal Reserve; and fiscal and regulatory policy, which are set by the president and Congress.
First there is the monetary policy response, which in turn moves aggregate demand. When the Fed raises interest rates, mortgages and business loans become more expensive. This dampens prices but also economic activity. It’s clear that the Fed can eliminate inflation—as it did under Paul Volcker in the 1980s—but with the potential cost of a (possibly severe) recession. The consensus high-level view, then, is that the Fed ought to only counterbalance excess demand, while ignoring temporary supply side shocks. The Fed is proceeding cautiously as it tries to determine just how temporary and large are the current supply shocks.
Second, on the fiscal policy side, reducing spending and/or raising taxes can reduce aggregate demand and thereby bring inflation under control. Sen. Joe Manchin’s proposed revision of the Build Back Better bill, which would include more new revenue than spending, could have that effect. But not all actions in this area require congressional action. The Biden administration could, for example, reduce Medicaid spending by ending the public health emergency and the additional transfers to states that come with it. The administration could also end the moratorium on student loan payments, which in addition to reducing demand would have attractive distributional implications. It could also work to reclaim some of the excess funds transferred to state and local governments, to keep those levels of government from contributing to additional inflationary pressures.
Using fiscal policy to reduce excess aggregate demand has some clear advantages over using monetary policy. Policymakers have much more nuanced tools than the Fed’s blunt instruments. This is important because any economic demand-dampening could have major distributional consequences. The political branches are subject to more direct democratic accountability and control than the Fed, and are therefore better suited to deciding where the pain will fall.
Also, using fiscal policy limits the extent to which the Federal Reserve will have to raise interest rates. This is attractive not just for political reasons (the stock market!) but also from a fiscal-sustainability perspective. If interest rates do not have to rise as much thanks to fiscal tightening, the federal government will not see interest payments on its debt rise as fast. This may sound like a minor issue, but federal debt held by the public is now around 100 percent of GDP, and every percentage point of interest-rate increases corresponds to a percentage point of GDP in additional spending, or over 5 percent of federal revenue.
Of course, the best solution is to limit the extent of dampening required. Again, whatever the cause of our current inflation woes, the ideal solution is not for aggregate demand to shrink but for aggregate supply to catch up. While the Fed cannot realistically expand aggregate supply, the administration should make that an urgent goal.
Which brings us to regulatory policy. A great place to start expanding supply would be addressing inefficient regulation. Unfortunately, President Biden’s proposals in this area have been lackluster. In his State of the Union address he proposed four anti-inflation measures: price controls for prescription drugs; subsidies for weatherization and electric vehicles; subsidies for childcare; subsidies for home and long-term care; housing subsidies; and subsidies for pre-K.
Even setting the fiscal impact aside, what these measures will mostly do is drive up demand, and with that, pre-subsidy prices for a broad range of services. Unfortunately, the president mostly doubled down on this approach in his remarks yesterday, when he added new housing and agriculture subsidies to the mix.
But there are better alternatives. Releasing oil from the Strategic Petroleum Reserve remains a smart short-term way to expand the supply side of the economy. Unlike gas tax cuts, it reduces consumer prices without inflating demand. It would be even better to remove regulations interfering with energy development and production.
The president could also eliminate the Trump-era tariffs. According to research from the Peterson Institute by Sherman Robinson and Karen Thierfelder, eliminating the tariffs on steel and aluminum, the tariffs on Canadian softwood lumber, and the tariffs related to the trade war with China would reduce the CPI by 1.3 percentage. These measures alone would thus cut excess inflation by 25 percent. But when asked about the China tariffs yesterday, Biden said only that “we’re discussing that.”
Immigration is another obvious area where the president can take certain actions without awaiting congressional approval. That admitting more high-skilled immigrants would be beneficial across the board is one of the rare areas of consensus among economists. While immigrants in general add to both the demand side and the supply side of the economy, their arrival in increased numbers would reduce inflation in three ways.
First, they would make workers who are already here more productive by letting them focus on their strengths. Second, they could help accelerate the sectoral reallocations the economy is going through, by facilitating the process of matching workers to sectors and locations that now face a greater demand for their output. And third, their arrival would help spread out existing excess demand over a larger supply side, so to speak. According to research from the Cato Institute’s Alex Nowrasteh and Michael Howard, well over 2 million fewer legal immigrants have come to the United States over the past five years than prior trends might have suggested. Such a number of additional people, many of them workers, would reduce inflation by a similar amount as the tariff elimination discussed earlier. And remember—this would simply take us back to the pre-Trump trend in the immigrant population.
Finally, two major areas of the economy where the public sector plays a dominant role are health care and housing. In the health care industry, the federal government plays a direct role as a payor and a price-setter. There is no reason why this pricing power should be used to target the pharmaceutical industry, as Biden suggested in his SOTU. After the miraculous development of vaccines we witnessed in 2020, and the possible further breakthroughs that could arise from some of the innovations of the last year or two, that industry arguably deserves applause and encouragement more than scorn. But there is no reason not to moderate the pace of growth of taxpayer-funded reimbursements for providers, as we did for much of the 2010s. At the very least the administration could strive to end COVID-era enhanced Medicare payments to providers.
In the housing industry, the government plays a major role in setting mortgage conditions and in land use policy. While states and localities play the leading role in the latter area, the federal government should incentivize them to liberalize land use. It may take a while for construction to happen, but that is helpful in this case. Remember that home prices are forward-looking asset prices: expectations of increased supply tomorrow will tend to reduce prices today. At the same time, delayed construction avoids inflationary pressures in the short run.
Sadly the administration’s proposal of additional, presumably temporary, housing tax credits does the opposite: It incentivizes construction activity right now, and raises prices by increasing demand without loosening supply restrictions.
Biden’s political team may be nervous about some of these measures—but is their inflation problem really hurting them less than Pennsylvanians’ fear of H-1B workers may? Just the trade and immigration changes we have highlighted here might cut excess inflation by half.
Defeating inflation requires either reducing demand to meet supply or boosting supply to catch up to demand. Maybe we will luck into that happening naturally. But in the 1980s, defeating inflation by reducing demand required an awful recession, with 10 percent unemployment. There is no reason to repeat that experience. By the time the Fed intervened in the 1980s, inflation had been elevated for years and expectations had shifted upward accordingly.
We are not in that situation yet, and between Federal Reserve action and some of the measures suggested here it is a situation we should be able to avoid. In fact, financial conditions have already tightened significantly, without, for now, wreaking havoc in the labor market. That does not mean avoiding a painful recession will be easy. But the sooner the administration starts taking the problem seriously, the better the odds of a soft landing.