The COVID pandemic caused sharp and deep setbacks to the U.S. economy, but it bounced back dramatically with the fiscal and monetary stimulus that followed. A new paper by experts at Wharton and elsewhere has analyzed the stimulus programs to understand why “the U.S. economy behaved unusually during and after the 2020 COVID recession” in four areas: economic output, inflation, house prices, and unemployment.

The paper, titled “Printing Away the Mortgages: Fiscal Inflation and the Post-COVID Housing Boom,” is authored by Wharton finance professors William Diamond and Tim Landvoigt, and Penn economics doctoral student German Sanchez Sanchez. The authors paired data on the four areas they tracked with a model they designed to “understand and decompose” the various channels by which the stimulus programs shaped the post-COVID economy.

Standard macro models are not designed to capture the unusual outcomes of the COVID stimulus programs, Diamond said. “But given that we’ve seen those outcomes, we ask the question: What unusual aspects do we have to put into our otherwise standard model to make sense of what happened?” The findings of the paper could also help policymakers refine their responses to future economic upheavals.

A Steep Fall, Then a Steep Climb

The paper listed the four key dimensions in which the U.S. economy behaved unusually: First, immediately after COVID was declared a pandemic in March 2020, unemployment had spiked dramatically to 14%, and then rapidly reverted to a 6% rate in 2021; it then continued to decline. Second, inflation was moderately low during 2020, after which it surged in 2021 and 2022 to a peak of 9% by July 2022; it has since fallen to about 3% as of July 2023. Third, house prices saw a rapid boom as they moved in tandem with the inflation spikes that followed the stimulus injections. A huge liquidity boost made up the fourth aspect, where overall money supply (or M2, which includes cash and bank deposits) surged from $15 trillion at the start of 2020 to more than $21 trillion in 2022.

The government and the Fed had intervened with “large-scale deficit spending, a massive increase in the supply of liquid assets, and loose conventional monetary policy,” the paper noted. The U.S. ran its largest primary deficits (before interest payments) on record in 2020 and 2021 of $2.5 trillion a year, largely because of generous direct cash transfers to households and unemployment insurance. The government also helped struggling households with a moratorium on home foreclosures and evictions, and supported businesses with loan programs. The Federal Reserve bought most of the debt those deficits created, thereby increasing its debt holdings from $2.6 trillion to $6.2 trillion. The Fed financed those purchases by increasing the supply of bank reserves from $1.7 trillion to $ 4.2 trillion. In addition, it held the federal funds rate at zero until early 2022, by which time inflation had crossed 8%, the paper noted.

Without government intervention, the recession would have been more severe and would have caused a severe rise in mortgages defaults and a drop in house prices, the paper stated. That is because homeowners would have lost their jobs and become unable to pay their mortgages, although unemployment insurance “considerably reduces the depths of the recession,” the authors added.

“The drop in output and employment was bigger than we have seen since the Great Depression. The boom in inflation was the biggest we have seen since the 1970s, [followed by] the fastest housing house price boom.”— William Diamond

Surprises in the Recovery

Diamond outlined what was surprising about the post-COVID recovery. “After the COVID shock, when we locked the economy down, that led to a large drop in output and a large drop in employment,” he said. “Unemployment went up faster than we’ve ever seen before, and then reverted pretty quickly.” He pointed out that in earlier recessions such as those in 2001 or 2007, “the recovery in employment often takes years, whereas here, most of the recovery occurred within a year.”

With inflation, it was “unusual and interesting” that while inflation fell during that initial lockdown period, it surged in 2021 and peaked in 2022, Diamond said. House prices followed the trend that inflation set during and after COVID, but with a lag of about a year, he noted.

But the contraction in the economy was contained in 2020 itself, Diamond continued. The massive stimulus interventions buttressed the economy. “Big drop in the economy, big policy response,” he noted. “One year later, we see a big boom in inflation and a big boom in house prices. But they don’t happen at exactly the same time.”

What was unusual about all those trends was “just how big everything was,” Diamond said. “The drop in output and employment was bigger than we have seen since the Great Depression. And then, the boom in inflation was the biggest we have seen since the 1970s, [followed by] the fastest housing house price boom.”

Aiding all that was a passive monetary response from the Fed, where it kept interest rates at zero throughout the COVID period and until April 2022. An active monetary policy response to inflation would have replaced the boom in inflation with a rise in interest rates earlier than the Fed acted, Diamond said.

Insights From Policy Analyses

The authors both theoretically and quantitatively analyzed the impact of the fiscal and monetary stimulus. The theoretical analysis produced two main insights: One, fiscal stimulus increases consumption demand in a recession by providing liquidity, by redistributing from savers to borrowers, and by lowering the return on saving if it causes future inflation. Two, future inflation only occurs if after the recession, taxes do not increase to pay for the stimulus.

The quantitative analysis studied the impact of a temporary shift to a passive monetary policy, or one that has a lower than one-for-one (or matching) responsiveness to inflation, with these findings: One, fiscally driven inflation enabled by a passive monetary policy reduces the real value of both mortgages and government debt. Thus, it increases the spending capacity and housing demand of credit-constrained homeowners. Two, together with transfer payments and large fiscal deficits during the COVID recession, this policy greatly reduces the recession’s severity and causes high house prices and inflation.

“Fiscal and monetary policy need to be coordinated rather than kept separate for maximum impact.”— William Diamond

How Inflation Triggers a Housing Boom

As inflation rises, it will reduce mortgage debt in the economy in real terms. “Any time you get a surge in inflation, you always get this effect of redistribution between borrowers and lenders,” Diamond said.

The paper pointed out a unique feature of its model when inflation erodes the real value of debt securities: “When the government inflates away its debt after the COVID recession, a boom in house prices occurs too. This is because private sector mortgage debt is inflated away as well, transferring resources from savers to borrowers. Because borrowers’ demand for housing is constrained by the supply of credit, this inflation reduces their indebtedness and allows them to afford even more housing.” Such a house price boom is, however, transitory and prices will revert to earlier levels when the central bank raises interest rates to control inflation, it noted.

The paper is the first to connect inflation caused by lax fiscal policy to the redistributive effects of inflation on asset and house prices.

Policy Takeaways for Creating a New Stimulus Package

A fiscal stimulus where households get direct cash transfers has a delayed impact built into it, but that is not well understood, Diamond said. “If wages stay rigid, giving a bunch of people checks is just going to help them pay their bills,” he added. “But if the money is still there a year from now, if you do not make the money disappear by taxing it away, you might get inflation in the future from that. Our model shows that fiscal stimulus that’s not paid for with future tax increases tends to cause delayed inflation once the economy is back to a more normal state.” Had the central bank realized that aspect, it might have raised interest rates sooner than it did, he added.

“If we have a new recession, which is not pandemic related, this idea of an interaction between fiscal and monetary policy is important, where you prime the pump by giving everybody checks,” Diamond said. “Therefore, the central bank is able to, if they want, cause a surge in inflation by having easy monetary policy. So, if you think that there’s too much debt in the system and you want to inflate some of it away, first give people checks and then do easy monetary policy. The interaction between the two is really what seems to be the surefire policy. Handing out checks during a severe crisis gives the monetary policymaker more space — that’s something we’ve learned from the COVID episode. Fiscal and monetary policy need to be coordinated rather than kept separate for maximum impact.”