Is High Inflation a Risk in 2021?

Is High Inflation a Risk in 2021?

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INSIGHTi
Is High Inflation a Risk in 2021?
April 6, 2021
Assuming public health continues to improve, many economists project rapid economic growth in 2021.
The unprecedented fiscal and monetary stimulus in response to the COVID-19 pandemic is also expected
to continue in 2021. Some observers have questioned whether the combination of stimulus and rapid
growth wil result in rising prices.
Historical Trends in Inflation
The economy experienced persistently high inflation in the 1970s and early 1980s, last reaching double-
digits in 1981 (see Figure 1). Most economists believe this high inflation was caused by overly
expansionary monetary and fiscal policies, along with significant increases in energy prices. Additional y,
as expectations of higher inflation became incorporated into consumer and business decisions, these
expectations contributed to actual increases in inflation. The Federal Reserve (Fed) raised short-term
interest rates significantly in the early 1980s, which successfully brought inflation down quickly, though
at the cost of a recession.
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Figure 1. Inflation Rate
January 1960 to January 2021

Source: Federal Reserve Economic Data (FRED).
Since 1991, inflation has remained below 5%, and inflation expectations have been low and stable. Since
the 2007-2009 Great Recession, inflation has mostly been below the Fed’s target of 2% (established in
2012) despite the fact that fiscal and monetary policy seem to have been more stimulative than they were
in the high inflation period of the 1970s and early 1980s. Adjusting for inflation, however, lowers the real
interest rate, making monetary policy more stimulative in the 1970s than it might appear. Figure 2 shows
the Fed’s short-term interest rate—the federal funds rate—both nominal y and adjusted for inflation.
Figure 2. Federal Funds Rate
January 1960 to February 2021

Source: CRS calculations using FRED data.

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The Fed kept short-term interest rates near zero from late 2008 to late 2015 and again in 2020 in response
to the pandemic. The Fed has also made large-scale asset purchases (popularly cal ed “quantitative
easing”) during both periods, resulting in historical y rapid growth in the money supply. At the same time,
federal budget deficits have been larger as a share of GDP from FY2009 to FY2012 and in FY2020 than
at any time since World War II (see Figure 3).
Figure 3. Federal Budget Balance as a Share of GDP
FY1946-FY2020

Source: Source: Office of Management and Budget.
The recent period of low inflation despite simulative fiscal and monetary policies is likely due, in part, to
the 2007-2009 Great Recession and the COVID-19-induced recession—the two deepest recessions since
the Great Depression. In both downturns, rapidly fal ing output and rising unemployment made a rise in
inflation unlikely. Although historical y large, fiscal and monetary stimulus were unable to fully offset
these economic shocks. Even when unemployment became low in the years preceding the pandemic,
inflation was contained, and inflationary expectations remained stable. Globalization, technological
innovation, demographics, and various other factors have been offered as additional forces countering
inflationary pressures.
2021 Outlook
Many observers expect a combination of rapid economic growth and the continuation of highly
expansionary monetary and fiscal support in 2021, raising concerns over the potential for higher inflation.
For example, the Fed has pledged to keep short-term interest rates at zero until the economy reaches full
employment and inflation is modestly above 2%—which Fed leadership does not expect until 2023 at the
earliest. On the fiscal side, the budget deficit is projected to be around 15% of GDP in FY2021 fol owing
the enactment of the American Rescue Plan Act of 2021 (P.L. 117-2).
Some economists believe that P.L. 117-2 is too large relative to the output gap and wil result in the
economy overheating, with the potential for a significant increase in inflation. The output gap is the
difference in actual output and potential output (i.e., what the economy is capable of producing when it is
at full employment). Even though the output gap is currently large, and therefore inflationary pressures
are low, rapid growth and too much fiscal and monetary stimulus could cause actual output to overshoot

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potential output, causing the economy to overheat. Further, it is uncertain if potential output wil return to
its pre-pandemic trend. Lockdowns, social distancing, and fears of being infected disrupted production in
2020. While some of those disruptions have been al eviated, others remain in place. Thus, output in 2021
may be much closer to potential than the pre-pandemic trend would indicate, given prevailing health-
related barriers to economic activity. If so, the likelihood of inflation rising could be higher.
Another unusual development in this recession is that personal income has risen because of the various
income support measures included in recent fiscal stimulus packages. As a result, and in part because
spending opportunities were constrained by the health situation, the personal saving rate rose from 7.5%
in 2019 to 16.3% in 2020. Once health conditions normalize, consumers may spend down some of this
savings, which could cause the economy to overheat.
Despite these concerns, most forecasters and policymakers expect inflation to remain low. Fed leadership
projects that inflation will rise modestly to 2.4% in 2021 before decreasing to 2%. But if an overheating
economy caused inflation to rise too quickly or be persistently high, fiscal and monetary policy could, in
principle, be tightened (through reduced deficits and higher interest rates, respectively) until inflation was
contained. This would run the risk of causing another recession, however. Thus, whether a long-term rise
in inflation would be prevented depends on policymakers’ wil ingness to tighten policy sufficiently if
necessary. (The fact that inflationary expectations have remained low suggests that investors believe they
would, and it makes it easier to avoid a long-term rise.) The Fed is statutorily required to maintain price
stability. Its current plans to modestly overshoot its inflation target and keep interest rates at zero until full
employment is restored are untested, however, and raise questions about the Fed’s wil ingness to raise
rates if inflation rose before full employment was restored. Likewise, Congress might find it difficult to
quickly reverse fiscal stimulus were high inflation to persist.

Author Information

Mark P. Keightley
Lida R. Weinstock
Specialist in Economics
Analyst in Macroeconomic Policy

Marc Labonte

Specialist in Macroeconomic Policy

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff
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