What if the Federal Reserve Has Inflation All Wrong?

The dominant U.S. inflation narrative has blamed pandemic stimulus for rising prices. But what if the money supply isn’t the real problem anymore?

AccessTimeIconJun 22, 2022 at 5:42 p.m. UTC
Updated May 11, 2023 at 6:10 p.m. UTC
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New data this morning showed inflation in the United Kingdom has hit 9.1%, beating out the rates in the U.S., Italy, France and all other G7 nations. That highlights a possible disconnect between the rationale behind tightening U.S. monetary policy and the actual causes of ongoing inflation rises.

You see, since the beginning of U.S. pandemic relief spending in 2020, prominent neoliberal economic voices have warned of the danger of America’s big-spending approach to cushioning the pandemic shock. The U.S. spent more as a share of GDP (gross domestic product) than any major economy on Earth, in a mix of direct payments to citizens, forgivable loans to small businesses and new pandemic-related federal spending.

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From nearly the beginning of that fiscal response, figures like Harvard economist Larry Summers warned that it could trigger inflation. For a while, they seemed right – until roughly the end of 2021, U.S. inflation did outpace the average for Organisation for Economic Co-operation and Development (OECD) countries. But with inflation around the world now surpassing U.S. levels, that story is increasingly open to doubt. Median inflation globally hit 7.9% in June, with the U.S. ranking just 48th out of 111 countries.

So if the U.S. printed a bunch more money than other economies, why are we all getting the same dose of inflation? The most compelling theory is that the particularly generous U.S. stimulus juiced inflation stateside for a while, but that effect has been largely supplanted by non-monetary factors that are hitting everyone. Those factors are pretty obvious: COVID and war.

Even without any pandemic relief at all, COVID would have created major price pressures. Wages have risen sharply even since the end of expanded U.S. unemployment benefits, in part because the labor force participation rate for prime-age workers cratered in the early stages of the pandemic, and still hasn’t recovered to 2019 levels. While supplemental income made it easier, some workers would still have chosen to avoid risks to their health by staying home. Others (largely women) were forced out of jobs by the loss of support systems like childcare.

At the same time, the grim reality is that the labor force has also been reduced by illness and death. Wages rose for similar reasons after the Black Plague decimated the European peasantry, centuries before there was any such thing as unemployment insurance.

It’s also vital to remember that pandemic relief, particularly Trump-era unemployment enhancements and stimulus checks, not only helped keep Americans safe by making it easier to stay home, but also helped the American economy experience a shorter recession and stronger recovery than any other advanced economy. For this, we can thank Steven Mnuchin, the Trump Treasury Secretary who clearly learned the lesson of the Obama administration’s anemic fiscal response to the 2008 financial crisis, which helped drag out the subsequent recovery.

Not ‘transitory’

Around the world, meanwhile, COVID also caused major supply chain disruptions that pushed up prices. The prime example is commodity silicon chips, with shortages continuing to constrain the supply of new automobiles. One reason leaders, including Janet Yellen, considered early signs of inflation merely “transitory” was that the bulk of it came from specific disrupted sectors such as autos. Most notoriously, the price of used cars in the U.S. spiked brutally in 2021 and has only recently begun to tick down.

And now, of course, there’s Russia’s invasion of Ukraine. That has had immediate impacts on energy markets thanks to limits on the export of Russian oil. It is beginning to have what could be catastrophic effects on food prices as Putin’s forces steal Ukrainian farms, which are among the most productive in the world. Chip shortages affect particular sectors like cars, but oil and food prices feed into the cost of nearly everything.

So we may be living through a transition between two distinct drivers of inflation – from money supply-driven price growth to supply-constraint price growth. The two are hard to entirely disentangle, because pandemic stimulus money is still driving some amount of U.S. spending. But with countries that did nothing close to the U.S. levels of spending now seeing MORE inflation than the U.S., it simply makes little sense to continue accepting Larry Summers’ version of events. In a few years, hindsight might vindicate dovish figures like Yellen.

Yet attention in the U.S. remains focused on the actions of the Federal Reserve, which has begun a cycle of aggressive interest rate hikes designed to shrink the supply of U.S. dollars in circulation. It’s one of a bare handful of tools the Fed has, and the Fed has the most explicit responsibility among U.S. institutions to maintain price stability.

Demand destruction

But if the money supply isn’t really the problem, what impact will the Fed's tightening have?

On the one hand, it’s pretty simple: Instead of limiting demand for specific sectors where real-world supply constraints are driving up prices, Fed tightening will cool demand for pretty much everything, largely by destroying people’s jobs. Inflation hawk Summers thinks we need to nearly double unemployment to 6% for several years to control prices – a truly devastating scenario for many workers and businesses. As the old saying goes, if all you have is a hammer, everything starts looking like a nail.

That means not just a temporary slowdown, but perhaps even long-term damage to the U.S. economy. Productive employees will lose their jobs, and productive facilities will be mothballed – both changes that are hard to reverse when things pick back up. In some sense, we traded an immediately catastrophic pandemic crash for something slower, and hopefully less traumatic, but not much less challenging.

And that demand destruction won’t actually increase the global supply of Russian oil or Ukrainian wheat. It just means fewer people will be competing for the same supply of food and energy, because they’ll be out of work.

This is the logic of inflation-fighting inherited largely from Paul Volcker, the Federal Reserve chair from 1979 to 1987, who infamously triggered a major recession in the early 1980s to fight inflation. That inflation, too, was at least partly driven by supply-side rather than demand-side problems, particularly a lengthy oil crisis caused by war in the Middle East.

The good news is that while that recession was intense, Volcker’s tough love set the stage for a huge U.S. economic expansion that arguably ran from the mid-1980s into the late-1990s. So while we might wish the Fed had more nuanced tools than a mallet poised to squash the entire economy, or that political leaders had more wherewithal to enact targeted policies, pain now could still mean a more stable, healthier situation not too far in the future.


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David Z. Morris

David Z. Morris was CoinDesk's Chief Insights Columnist. He holds Bitcoin, Ethereum, and small amounts of other crypto assets.