U.S. inflation has recently spiked to levels not seen since the 1970s. Economists have sought to understand the causes of this unexpected surge, which followed the COVID-19 pandemic.¹

The U.S. government's immediate response to the economic collapse caused by the pandemic was a series of fiscal transfers in 2020-2021 that included the Coronavirus Aid, Relief, and Economic Security Act; the Coronavirus Response and Relief Supplemental Appropriations Act; and the American Rescue Plan. These fiscal transfers together amounted to 11 percent of gross domestic product (GDP) in 2019 dollars. What was the impact of these enormous transfer payments on the macroeconomy?

For their paper "Are Fiscal Transfers Inflationary? " Jonas Arias and Minchul Shin of the Philadelphia Fed and Juan Rubio-Ramírez of Emory University and the Atlanta Fed (as well as a visiting scholar at the Philadelphia Fed) studied the evolution of the U.S. economy during the pandemic with a particular emphasis on the role played by fiscal transfers in determining the dynamics of inflation and output. Using a recently developed econometric framework, they examined how key macroeconomic indicators interacted with each other and responded to unexpected shocks over time, how effective fiscal transfers were and at what cost in terms of inflation, and the role that monetary policy played in shaping macroeconomic outcomes.²

The authors used an econometric model, technically known as a rotation-invariant time-varying structural vector autoregression, to quantify the main forces behind changes in the economy.³ In particular, their framework allowed them to disentangle the contributions to output growth and inflation from fiscal transfer shocks; from demand shocks (resulting from, for example, the economywide shutdown early in the pandemic); and from monetary policy shocks from unexpected policy rate adjustments, which affect borrowing costs. They also studied supply shocks - specifically, those stemming from global supply chain shortages - as well as cost-push-related supply shocks.

They found that demand shocks initially had a negative impact on both output and the price level as private spending collapsed in 2020. Later, some positive demand shocks occurred from, for example, pent-up demand following the lockdown. This pent-up demand boosted output and reversed the downward pressure on the price level exerted by the spending collapse at the onset of the pandemic. But overall, these demand shocks were not meaningful contributors to inflation during the pandemic - although they did contribute to the rise in short-term interest rates during the recovery phase. Meanwhile, they found that monetary policy shocks overall caused prices to be lower than they otherwise would have been. (This is because the effective lower bound on interest rates left the monetary authorities little room to lower rates further to stimulate the economy.)

Postpandemic fiscal transfer shocks, however, significantly lifted output and accounted for a sizable share of the inflation that occurred through mid-2021. These payments dramatically improved economic activity, but this effect was short-lived, with their contribution to GDP diminishing by the end of 2021. The transfers raised the GDP deflator (which measures the price level) by 5 percent in 2021 alone and continued to contribute significantly to the price level through the end of 2024. Even so, fiscal transfers were not the main driver of the price level surge.

It was instead the supply shocks that occurred from 2021 onward, reflecting widespread global supply bottlenecks and disruptions in logistics, that contributed the most to inflation and also negatively affected output. To cite just one example, supply-side price pressures mounted because of the global semiconductor chip shortage, creating supply chain disruptions for many U.S. manufacturing industries. Cost-push supply shocks further contributed to inflation, including through product price markups.

How did monetary policy influence macroeconomic conditions during the pandemic? Early in the pandemic, monetary policy was contractionary, as the effective lower bound prevented the Federal Reserve from reducing the federal funds rate below zero in the first half of 2020. This contractionary policy weighed on output and the price level. Thereafter, the monetary policy response was expansionary because, through the lens of the econometric framework, the Federal Reserve delayed raising interest rates. Even so, this delayed response was not enough to make monetary policy's overall contribution to the price level positive during the pandemic era.

To learn more about the role of monetary policy in shaping how the expansion of fiscal transfers propagated through the economy, the authors compared the monetary policy response to fiscal transfer shocks during the pandemic with the response during the Great Recession (2007-2009). During the Great Recession, fiscal transfers were about one-quarter of those during the pandemic, and output contracted sharply. Meanwhile, the monetary policy response was systematic and strong, preventing significant inflation, although at the cost of providing weaker support for output. In contrast, a more muted policy response occurred following the pandemic, amplifying the output effects of the transfers but failing to prevent the fiscal transfer shocks from fueling inflation.

Using counterfactual analysis, the authors replaced the Great Recession's fiscal shocks with the large transfers from the pandemic and found that prices would still have risen, but more modestly than during the pandemic. This is because interest rates would have increased much more during the Great Recession as a result of systematic monetary policy adjustments.⁴ Their findings underscore that monetary policy plays a critical role in how fiscal transfers impact the macroeconomy.

They conclude that, despite the unwanted inflation, U.S. fiscal transfers during the pandemic were essential in preventing an output collapse similar to the one experienced during the Great Depression. Without these transfers, real GDP per capita would have fallen by over 20 percent, rivaling the decline during the early 1930s. The cost of these transfers has been a sizable increase in the price level through mid-2021 with diminishing but persistent positive contributions to the price level through the end of 2024.