December 2023

What caused the high inflation during the COVID-19 period?

Summary written by: Lawrence H. Leith

The COVID-19 pandemic profoundly affected the world economy. The U.S. economy lost 23 million jobs at the start of the pandemic, leading to a recession in early 2020. The federal government responded with sharp increases in fiscal spending, and the Federal Reserve lowered interest rates to near zero and kept them there for almost 2 years. The economy began to recover, but inflation rose to its highest level in decades. This led to debates among economists about what caused the high inflation rates and how best to lower them. In a recent conference paper, “What caused the U.S pandemic-era inflation?” (presented at the Brookings Institution, Washington, DC, May 23, 2023), Ben Bernanke and Olivier Blanchard analyze the complex set of factors that led to the highest inflation rates in more than 40 years.

In their literature review, Bernanke and Blanchard divide policy analysts into two groups: the “inflation optimists” and “the critics” (counting themselves among the latter). As the authors explain, standard economic theory suggests that easing fiscal and monetary policy can increase inflation if labor markets overheat and output exceeds the economy’s potential. The inflation optimists argued that even if the new policies caused the unemployment rate to decline more than is optimal (i.e., below 4.0 percent), any resulting rise in inflation would probably be minimal and temporary. By contrast, the critics argued that the large fiscal transfers and easing of monetary policy risked increasing aggregate demand to the point of overheating the labor market and thus increasing inflation.

Bernanke and Blanchard introduce an analytical model that focuses on the behavior of wages, prices, and short- and long-term inflation expectations, with labor market slack and shocks to prices taken as given. The authors use empirical data on wages and prices to test their “model of wage-price determination.” They examine data from two periods: first quarter 1990 to fourth quarter 2019 (the pre-COVID period) and first quarter 2020 to first quarter 2023 (the COVID period). The model allows the authors to “decompose” price and wage inflation and determine its sources at a more specific level. In particular, they examine demand issues, such as food and energy prices, and supply issues, such as the shortages caused by production shutdowns and other supply-chain disruptions during the pandemic. In addition, Bernanke and Blanchard use the ratio of job vacancies to unemployed workers in their analysis, arguing that it measures labor market tightness more accurately. The ratio increased from less than 1.0 in April 2021 to 1.9 a year later, the highest level on record.

From their analysis, the authors present three main findings:

1. The shocks to food and energy prices contributed substantially to the sharp rise in inflation during the COVID-19 period. Energy price shocks were the primary cause of the high inflation rates from late 2021 to the middle of 2022. Lower energy prices in the second half of 2022 contributed to the inflation decline during that period.

2. The combined effects of increased demand for durables and shortages caused by supply-chain disruptions were the main source of inflation in the second quarter of 2021. Both the direct and indirect effects of those supply-chain problems remained substantial through the end of 2022.

3. Tight labor-market conditions, one of the main concerns of the early critics of U.S fiscal and monetary policy, contributed only slightly to inflation. In fact, the tight labor market affected the economy negatively in 2020 and early 2021. Since then, however, the traditional Phillips-curve effect has begun to reemerge, with the high vacancy-to-unemployment ratio becoming an increasingly important factor in the high inflation rates.

Bernanke and Blanchard argue that the critics’ concerns of higher inflation were correct. But the sources of the high inflation differed from those the critics had anticipated. The authors conclude that price shocks in product markets were the leading cause of the initial rise in inflation. However, as labor markets began to overheat in 2022, with unsustainable employment increases, a high ratio of job openings to unemployed workers, and low levels of quits, labor market tightness increasingly became the main cause of the persistently high inflation rates.