The New York Times recently published an article discussing polling data on inflation. It explained that most Americans are “somewhat concerned” if not “very concerned” about inflation but disagree on its cause. The article’s author, Ben Casselman, shared a graph of the causes of inflation as perceived by the public.
Strikingly, the Federal Reserve’s monetary policy, the single most important cause of inflation, is not on this list. One of the answers (“Corporations”) is almost certainly not an important factor; and while stronger arguments can be made for the other four answers, they cannot explain most of the present inflation.
The Fed, Monetary Policy and Inflation
The Fed has a congressional mandate to produce “maximum employment” and “price stability.” It attempts to achieve unemployment and inflation rates it deems consistent with this mandate by buying and selling assets, adjusting the interest rates it administers and communicating what it expects future policies to look like. Prior to August 2020, the Fed had a simple 2% inflation target, where it would attempt to produce 2% inflation without considering whether it had previously missed this target. In August 2020, the Fed switched to “flexible average inflation targeting,” where its new goal was to achieve 2% inflation on average—that is, the Fed would take previous misses into consideration as it sets policy.
As I have written before, one way to think about the Fed and inflation is to compare the Fed to a thermostat (an analogy made popular by the late economist Milton Friedman). A good thermostat regulates the temperature of a house by offsetting it against the weather outside. Similarly, a good central bank sets monetary policy to keep inflation at target by offsetting other factors. Presently, the Fed is not being a good thermostat, because both current inflation and expected future inflation are well above the Fed’s 2% average target. In March, the Personal Consumption Expenditures Price Index, the Fed’s preferred measure for inflation, grew at annualized 6.3%. Economist William Luther shows that bond markets are expecting 3.3% and 2.9% inflation over the next five and ten years, respectively. If the Fed wishes to be perceived as credible (i.e., demonstrate that it is a good thermostat), it needs to tighten monetary policy more quickly.
The American Rescue Plan
The American Rescue Plan was the $1.9 trillion stimulus plan passed by Congress and signed into law by President Biden in March 2021. Critics, including former Treasury Secretary Lawrence Summers, warned that the bill was excessively large, especially given the two previous stimulus packages under the Trump administration and the Fed’s continued accommodative monetary policy. Summers and others based their assessment on the “output gap,” which is the difference between actual output (real GDP) and potential output (what economists estimate to be the highest level of output the economy can sustain).
If actual output is below potential (output gap is negative), the government can stimulate the economy to increase actual output. If actual output is above potential (output gap is positive), actual output is unsustainable, resulting in inflation. Since the ARP was too big relative to the economy’s potential output at the time, Summers and other critics argued, inflation would result. Many people now view the past year as a vindication of Summers and his fellow travelers. A recent article in Vox makes this argument and surveys some of the studies that support it.
Although this narrative seems to accurately describe what is happening right now, it omits a critical factor: the Fed’s response. Yes, the ARP led to increased total spending in the economy (otherwise known as nominal GDP), but only because the Fed chose not to offset this stimulus with a tighter monetary policy. If you’re going to blame the White House and Congress for contributing to inflation by spending too much money, Fed Chair Jerome Powell and the other members of the Federal Open Market Committee deserve a greater share of that blame.
The ARP was an exercise in fiscal stimulus—that is, spending more money in hopes of jump-starting the economy. Many economists believe expansionary fiscal policy (lower taxes and more spending) can be used to stimulate nominal GDP growth, while contractionary fiscal policy (higher taxes and less spending) can be used to curtail inflation. However, there is abundant evidence that monetary policy dominates fiscal policy in determining both nominal GDP and inflation. In 1968, President Johnson and Congress balanced the budget and raised taxes to reduce high inflation, but inflation continued to rise because the Fed pursued an expansionary monetary policy. Similarly, even though the budget deficit rose rapidly during the Reagan administration, inflation fell because Chair Volcker pursued a tight monetary policy.
This does not mean that Congress and the president should never use fiscal policy to achieve economic goals. For example, a case could be made for spending money to improve the quality of infrastructure or schools, or for reducing taxes to enhance the efficiency of certain sectors in the economy. However, fiscal stimulus is not the best way to put more money into people’s hands to help them get out of an economic slump.
An exception to the rule that fiscal policy is not the ultimate determinant of inflation is “fiscal dominance.” This is when the central bank lacks independence and must conduct monetary policy to support the government’s fiscal policy. Governments typically rely on taxation and borrowing to fund whatever policies their leaders choose to pursue. However, grossly mismanaged governments can find themselves unable to bring in sufficient tax revenue to service their debts or to access credit markets because they are considered poor credit risks. Such governments then turn to the central bank to keep interest on their debts low and to create money to fund their policies.
The U.S. is fortunately not in a position where monetary policy is subservient to fiscal policy. But could we find ourselves in a fiscal dominance scenario someday? My Mercatus Center colleague David Beckworth argues that the demand for U.S. Treasury debt is so strong that the U.S. can sustain large debt levels without resulting in fiscal dominance. However, my other Mercatus colleagues, Veronique de Rugy and Arnold Kling, are less sanguine. They argue that to avert fiscal dominance, the U.S. needs to take drastic measures to reduce the federal debt. Even the possibility of fiscal dominance is enough reason to practice fiscal rectitude. Nevertheless, it would be a mistake to argue that the Biden administration’s and Congress’ spending policies are a bigger factor than the Fed’s lax monetary policy in driving inflation.
The COVID-19 Pandemic, Supply Chain Disruptions and the Ukraine War
When discussing inflation, it is important to distinguish between demand shocks (those that affect the total amount of demand in the economy) and supply shocks (those that affect the economy’s potential output). Changes in monetary and fiscal policy are demand shocks. Supply shocks include anything that positively or negatively affects the economy’s ability to produce. Although inflation is ultimately determined by monetary policy, large supply shocks can affect the price level in the short term.
When inflation began to creep up last year, many economists (myself included) thought it was mostly due to the COVID-19 pandemic wreaking havoc on supply chains across the world. Were that the case, inflation would be temporary as people developed immunity and learned to live with the virus over time. Furthermore, the higher prices would encourage greater production, because companies would see higher prices as opportunities to earn greater profits. Then, as production increased, prices would start to fall.
While negative supply shocks explain some of the inflation, they cannot account for all of it. Everything else being equal, a negative supply shock raises inflation and reduces real GDP growth; but from the third quarter of 2020 throughout 2021, real GDP growth boomed. Moreover, both prices and nominal GDP are now well above their pre-pandemic trends. This is more consistent with the view that monetary policy causes inflation than the view that supply shocks do.
In fairness to those who got it wrong, it can be difficult to differentiate between supply shocks, such as a pandemic or a war, and demand shocks in real time. Moreover, when inflation is temporarily high because of negative supply shocks, tightening monetary policy does more harm than good. In 2008, negative supply shocks caused oil and commodity prices to rise. Although the American economy was weakening, the Fed was reluctant to ease monetary policy because it was worried about inflation. This left the Fed seriously behind the curve as the economic contraction intensified into the Great Recession.
Today, the Fed faces a different challenge. Monetary policy has been too expansionary, and the Fed needs to tighten it to rein in inflation and to restore the Fed’s credibility of taking price stability seriously. However, the war in Ukraine is a major negative supply shock and has sent both food and oil prices skyrocketing across the world.
The challenge posed by supply shocks is a big reason some economists argue that the Fed should target nominal GDP instead of inflation. This way the Fed could keep the total volume of spending on a stable growth path and only respond to changes in inflation caused by demand shocks rather than supply shocks. The case for nominal GDP targeting is particularly strong right now as the Ukraine war and other negative supply shocks threaten the economy.
Finally, some progressives such as Elizabeth Warren claim that corporations are using inflation as an excuse to price-gouge and thus worsening the inflation rate. As evidence, they point to corporations’ high profit margins and anecdotal evidence of CEOs acknowledging that they are taking advantage of inflation to set higher prices.
There are at least two major problems with this view, which unfortunately is shared by 40% of The New York Times survey respondents. First, companies are always doing the most they can to boost profits. However, for corporations to be able to set higher inflation-adjusted prices, they must enjoy some degree of monopoly power, or their competitors would undercut them by lowering their prices. A monopolist charges higher prices and produces lower output, which is inconsistent with the high output growth we’ve seen.
Second, blaming corporations for inflation gets causation wrong. As economist George Selgin has pointed out, nominal GDP growth strongly affects corporate profits. When nominal GDP growth rises, corporations tend to see demand for their products rise. When this happens, corporations have a strong incentive to raise their prices as they try to meet this demand and sell more of their products. Since corporations’ costs also tend to be somewhat fixed in the short run, profits rise. However, it’s monetary policy, not corporate greed, that is causing this rapid profit growth in the first place. As Selgin concludes, “If you don’t like seeing corporations making huge profits, and you don’t like high inflation . . . tell the Fed to do a better job stabilizing the [nominal] GDP growth rate!”
What is perhaps most dangerous about the corporate greed argument is that its proponents are calling for counterproductive policies that would reduce output and lead to even higher prices. Last week, House Democrats passed a bill banning “unconscionably excessive” gas prices. The bill is unlikely to pass the Senate, but if it were to pass and be signed into law, it would be a price control on gasoline. It’s basic economics that when a price cannot rise in response to demand, a shortage will result. Oil companies will have less incentive to increase production, which is critical in bringing down the prices of oil and gas.
The Washington Post’s Catherine Rampell, reporting on a similarly worded bill that would ban price gouging across industries, correctly excoriated “unconscionably excessive” as having no clear meaning and the bill as being unlikely to alleviate prices. She also rightly criticized Democrats’ proposed tax on high oil profits, which would reduce oil production just as we need more of it.
Non-monetary forces, such as fiscal policy and supply shocks, can temporarily affect the price level, and policymakers should aim to make the American economy as productive as possible to bring down high prices. Deregulation across sectors and more trade can help achieve these goals. That said, the Fed is ultimately responsible for price stability. The inflation buck stops with the Fed Chair. If we wrongly focus too much on non-monetary forces, we risk failing to hold the Fed accountable for its decisions.