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Can an economy pop from too much stimulus? That’s the concern behind “overheating,” a term that’s been the center of economic debate as the $20 trillion U.S. economy re-opens and recovers from the COVID-19 pandemic.
What is overheating?
As Treasury Secretary Janet Yellen once said, “expansions don’t die of old age.”
Overheating is one way for an economic expansion to end. There is no official economic definition for overheating. But one oft-cited indicator of overheating is inflation, or rising prices.
In a healthy economy, unemployment should fall (as people find jobs) and GDP should rise (as economic activity grows). Employed and with income, consumers will demand goods and services.
Producers may adjust prices to capitalize off of the increased demand (and pay for any associated increases in production). In turn, employees of those producers may ask for pay raises that net them more income. Those households can then demand more goods and services, rounding the cycle of wages and prices.
In an overheating economy, this loop repeats several times, leading to rounds of markups in prices and fueling runaway inflation. The so-called wage-price spiral was one of the factors in double-digit price inflation in the 1970s, the most notable example of economic overheating.
What happens when an economy overheats?
Runaway prices can quickly erode the purchasing power of a household. But it’s not the inflation itself that causes a recession.
To tame the hyperinflation beast, then-Federal Reserve Chairman Paul Volcker dramatically lowered the money supply and ratcheted up short-term borrowing costs, triggering a sharp pullback in economic activity.
The worry is that runaway inflation will again force the Federal Reserve to pump the brakes to dampen inflationary pressures, raising interest rates in a way abruptly ends the recovery.
So what level of inflation is concerning?
Economists have different definitions on what level of inflation constitutes “overheating.”
One challenge is parsing out true inflationary pressures from those that may be temporary or “transitory.”
If inflation is rising because of short-term constraints that are likely to fade in a few months, high inflation readings may not be of much concern to policymakers.
But if inflation is due to the wage-price spiral, a deeper, more entrenched dynamic may be at play.
This is why it is difficult to say that a reading of 4% or 5% year-over-year inflation means overheating, since it is all about the persistent nature of the price pressures leading to those readings.
What does this mean for the Fed?
The Fed has also taken note of the fact that inflation has been persistently low since the last crisis, which explains their new framework that will tolerate inflation “moderately” above its 2% target.
In other words, high monthly inflation readings in the early months of the pandemic recovery are not of immediate concern to policymakers.