Post-Pandemic Inflation in the US: The Impact of Government Spending and Monetary Policy

The COVID-19 pandemic disrupted economies worldwide, leading to sharp economic contractions followed by aggressive policy responses. As part of the recovery strategy, the United States implemented a combination of expansive fiscal policies and accommodative monetary policies. While these efforts helped stabilise the economy, they also contributed to an inflationary surge, the likes of which had not been seen for decades. In response, the Federal Reserve embarked on an aggressive monetary tightening cycle in 2022, aiming to curb the inflationary pressures that persisted even as the pandemic receded. However, the interaction between fiscal policy, monetary policy, and inflation is more complex than a simple cause-and-effect relationship, raising important questions about the effectiveness of these policies in controlling inflation in the post-pandemic era.

The US Inflation Surge Post-Pandemic

Following the pandemic, the U.S. saw inflation reach levels not witnessed since the 1980s. Central banks, including the Federal Reserve, were forced to act aggressively to combat this surge. Between March 2022 and August 2023, the Fed raised interest rates by 525 basis points-the most significant increase in over 40 years. Despite this action, inflation remained stubbornly high, especially in the service sector, which seemed impervious to monetary policy tightening. The persistence of inflation, particularly in core services, raised questions about whether the usual tools of monetary policy were still as effective as before.

The Role of Monetary Policy

Monetary policy, traditionally the primary tool for controlling inflation, operates through interest rates. The Federal Reserve’s recent tightening cycle was aimed at curbing inflation by reducing consumer spending and investment, which are sensitive to interest rates. However, examining the effectiveness of this policy requires a deeper dive into specific sectors of the economy.

Recent research has identified that certain components of core Personal Consumption Expenditures (PCE)-a key inflation measure-are particularly responsive to changes in interest rates. By analysing these “super monetary policy sensitive” components, researchers found that while many goods and services saw a decline in prices following interest rate hikes, core services like healthcare, education, and housing proved more resistant. This resistance can be attributed to the nature of these services, which are less affected by global supply chains and more reliant on domestic labor markets. The limited impact of rate hikes on services inflation suggests that while the Fed's monetary tightening has had a role in reducing inflation, it has not been as universally effective as in previous cycles.

The disinflationary trend began to stall in early 2024, leading the Fed to revert to a hawkish stance. Chair Jerome Powell acknowledged the challenges in his Jackson Hole speech, emphasising that the policy might need to adjust as inflation persists in key areas despite broader efforts to contain it. Thus, while monetary tightening has had a measurable impact on certain sectors, the persistence of inflation in services highlights the need for a broader policy response.

The Impact of Fiscal Policy on Inflation

While the Fed’s actions have garnered significant attention, fiscal policy has played an equally critical role in shaping inflationary trends. The pandemic led to an unprecedented level of fiscal stimulus, including direct transfers to households through programs like the CARES Act and the American Rescue Plan Act (ARPA). These fiscal interventions were designed to provide immediate relief to individuals and businesses but also contributed to increasing demand at a time when supply chains were disrupted.

Empirical studies indicate that fiscal transfers, particularly in the form of direct payments to households, acted as a significant driver of the inflation surge in 2021 and 2022. A closer analysis of fiscal shocks reveals that government spending, particularly on transfers, had a lasting impact on demand, further fueling inflationary pressures. These transfers injected a substantial amount of purchasing power into the economy, which drove up demand for goods and services while the economy struggled with supply-side constraints.

Interestingly, fiscal shocks related to government spending (such as infrastructure investments) have been shown to act more like supply shocks, with a limited immediate effect on inflation. In contrast, shocks to net tax revenue, which largely resulted from the fiscal stimulus packages, acted more like demand shocks and had a direct upward effect on inflation. These fiscal measures, combined with robust consumer demand, contributed to the persistence of inflation, particularly in service sectors like housing and healthcare, where inflationary pressures have remained high.

The Interaction of Fiscal and Monetary Policies

The post-pandemic inflation experience has highlighted the complex interaction between fiscal and monetary policies. Historically, monetary policy has been the primary tool for controlling inflation, but the sheer scale of fiscal interventions during the pandemic has complicated this relationship. Research has shown that the fiscal stimulus, especially in the form of direct transfers, had long-lasting effects on inflation, especially in the service sector, which is more labor-intensive and less susceptible to changes in interest rates.

The persistence of inflation in core services, despite the Fed's tightening efforts, suggests that fiscal policy-specifically the large fiscal transfers to households-has played a crucial role in sustaining demand pressures in these sectors. As the economy adjusted to the post-pandemic reality, the combination of supply chain disruptions, tight labor markets, and elevated demand resulted in a scenario where inflation remained persistent, particularly in services, despite the Fed's best efforts to cool the economy.

Conclusion

The post-pandemic inflationary period in the U.S. offers a clear example of how the interaction between fiscal and monetary policies can shape economic outcomes. While the Federal Reserve's aggressive interest rate hikes played a key role in reducing inflation in many sectors, they proved less effective in addressing the persistent inflation in core services. This persistence can be attributed to the large fiscal stimulus packages implemented in 2020 and 2021, which boosted demand at a time when supply chains were constrained and labor markets remained tight.

Looking forward, it is clear that both monetary and fiscal policies need to be carefully calibrated to manage inflation effectively. The Fed’s actions alone may not be sufficient to address the challenges posed by the pandemic-induced fiscal stimulus, particularly in sectors that are less sensitive to interest rate changes. As the disinflationary process continues, the interaction between fiscal and monetary policies will remain a key factor in shaping the trajectory of inflation in the post-pandemic economy.