After all, the Fed has raised its inflation forecasts significantly over the last 12 months. At its mid-June meeting, the policy-setting Federal Open Market Committee estimated that whole-year inflation in 2021 for personal consumption expenditures would be 3.4 percent. That is a full percentage point higher than their median projection in March, and more than twice the level forecast back in June 2020.

The rise in US inflation reflects a combination of temporary and structural factors. For example, while partial pandemic-related lockdowns have caused production to decline, large government stimulus programs have sustained household demand, which exceeds supply in many sectors. This component of today’s price increases would presumably disappear once output returns to its full potential.

But although Fed officials regard the current increase in inflation as largely transitory, it also has structural causes that are not entirely linked to the pandemic. For starters, US monetary policy has been on expansionary steroids since 2008. While the Fed’s response to the pandemic-induced recession increased the money supply further, policy was very loose well before the COVID-19 crisis, even when US unemployment was at a multi-decade low.

In addition, former president Donald Trump’s aggressive tariff increases on imports from China – from an average of about 3 percent in 2018 to over 20 percent within three years – raised the prices of imported goods, especially for low-income US households. They also increased the domestic prices of goods imported from countries such as Vietnam and Mexico, as well as those of US-made products that are substitutes for Chinese imports. Tariff hikes affecting parts and components imported from China further drove up the prices of downstream products.

Lastly, Trump’s 2017 tax cut and the subsequent fiscal stimulus programs under both Trump and President Joe Biden have boosted aggregate demand, adding to the upward pressure on prices. Many economists, including some prominent Democratic-leaning ones, think Biden’s US$1.9 trillion COVID-19 relief package is much larger than necessary given the estimated size of the US output gap.

To anticipate the international consequences of higher US inflation, we need to recognize the risk that the Fed may tighten monetary policy more suddenly and dramatically than its current 3.4 percent inflation forecast might suggest. For now, a majority of US households, firms, and investors still believe that the Fed will adjust the money-supply spigot in a timely, measured way to prevent inflation from getting out of hand.

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