In June of 2022, inflation rates in the United States soared to levels not seen in 40 years. The subsequent two years saw a significant decline in both the Consumer Price Index and Personal Consumption Expenditures-based inflation rates, despite sustained economic growth and a strong labor market. However, there is cause for concern as core inflation rates have recently stabilized or even shown slight increases.

There is currently a stimulating discussion in economic and financial circles regarding the potential inflationary consequences of the policies implemented during the Trump administration. Additionally, there are uncertainties surrounding the Federal Reserve’s ability to maintain its independence in light of the new political landscape.

Following a decade of unusually low inflation rates before the pandemic, the unexpected surge in general price levels from 2021 to 2022 had a lasting impact on consumer sentiment. This effect seems to have persisted through the disinflationary phase and likely influenced the outcome of the 2024 election.

Although overall price levels are still elevated, public expectations have not fully adjusted to the new norm. It is improbable that general price levels will return to their pre-pandemic levels. Instead, a stable level of prices (with low and consistent inflation rates around the Fed’s target of 2 percent) should be the desired outcome.

Forecasting inflation has become increasingly challenging due to recent volatility and policy uncertainties. Despite decades of deliberation, an economic consensus on the fundamental drivers of inflation dynamics is yet to be reached.

While Monetarism was prominent in the 1970s and early 1980s and experienced a resurgence in 2020 and 2021 due to significant increases in the U.S. money supply, the uncertainties surrounding money demand forecasting and the variability of money velocity have led experts to conclude that money supply growth does not offer valuable insights into short-term inflation trends.

Some proponents of the fiscal theory of the price level argue that fiscal policies, rather than monetary policies, primarily influence inflation. Decisions by the government on budget balances and public debt could play a pivotal role. Persistently high deficits and escalating debt without a concrete strategy for future revenue generation or spending cuts might lead to the perception that the government could resort to inflating away the debt burden, thereby raising inflation expectations and actual inflation.

Despite being relatively less favored in the central banking circles, the fiscal theory of the price level has gained attention. Mainstream approaches to understanding inflation dynamics mostly rely on a modernized version of the Phillips curve.

The Phillips curve-based view of inflation takes into account inflation expectations, economic slack, and supply shocks as key factors. It suggests that a tightening labor market in an overheated economy can drive upward price pressures, although the relationship between economic slack and inflation is variable.

The slope of the Phillips curve transitioned from being flat in the 2010s to steep in the aftermath of the pandemic shock, indicating a non-linear relationship. The curve is flat in normal labor market conditions but steep when the labor market is tight.

Between March 2020 and June 2022, a combination of fiscal stimulus, monetary policy accommodation, global supply chain disruptions, and energy price shocks led to an inflationary shock. Subsequent disinflation was possible due to restrictive monetary policies and the easing of supply chain disruptions.

Improvements in labor market conditions were noted as job vacancies increased and illegal migration surged, boosting labor supply and alleviating wage pressures.

The importance of anchored inflation expectations, as highlighted by Fed Chair Jerome Powell, played a significant role in facilitating disinflation efforts without the reliance on economic slack.

There are concerns about potential supply-side constraints due to strict regulations on cross-border labor flows. It is also speculated that Trump’s tariff proposals could increase price pressures and inflation expectations.

The Biden administration’s loose fiscal policy, with consistent budget deficits exceeding a trillion dollars annually, likely contributed to the inflation problem. The Trump administration’s approach, either through deficit reduction or unmitigated tax cuts, could have implications for inflation moving forward.

In the short term, there are risks of higher inflation due to increased aggregate demand from tax cuts, greater investment, and deregulation. Balancing supply-side constraints may become a challenge, especially if certain sectors of the labor market experience strain, although higher productivity growth could provide some relief.

Vivekanand Jayakumar, Ph.D., is an associate professor of economics at the University of Tampa.