Too many economists are still looking for inflation outside of monetary policy.
At the onset of the Covid pandemic, President Trump and Fed chairman Powell recreated a scene from Goethe’s drama Faust, where the Emperor is faced with insufficient funds for his long list of projects. Then Mephistopheles entered with a simple solution: Turn on the money pump. Like Mephistopheles, Powell “solved” the president’s problem.
When the Fed turned on the money pump, it reassured us that inflation wouldn’t appear. Once it did, the oracles at the Fed told us that inflation would only be temporary. The Fed and its Keynesian camp-followers cast around for scapegoats — they have blamed Covid-19, supply-chain disruptions, high oil prices, corporations not wanting to pay their fair share of taxes, price gouging, and, now, Putin.
They blamed everything except the factor that was most responsible — the Fed’s own monetary policy, which financed the vast increase in government expenditures since March 2020. Of course, other factors did play a role, but the Fed’s boosters ignored the monetary elephant in the room.
True to form, the Fed, as well as the White House, have the public looking for the causes of inflation in all the wrong places. The spread of this disinformation, which is disseminated with ease throughout the media, is designed to mislead the public as to who the real inflation culprits are.
It has not just been the media who have been manipulated (something that may not have been an uphill struggle). Professional economists have bought into this disinformation as well. Economists quoted in the Wall Street Journal continue to blame non-monetary factors such as the war in Ukraine and relative prices elsewhere in the economy as the primary cause of inflation. Under the circumstances, it was interesting to see the recent admission from the managing director of the International Monetary Fund, Kristalina Georgieva, who admitted that monetary policy-makers “didn’t really quite think through the consequence[s]” of printing too much money.
With the headline CPI inflation rate now at 8.5 percent and projected to rise further, the Fed’s chickens are coming home to roost. Elsewhere in the aviary some traditional doves are turning into hawks. For example, Lael Brainard recently acknowledged that the Fed must act quickly and aggressively against inflation, and that this will involve higher rates and a smaller Fed balance sheet. Neel Kashkari, someone else usually thought of as a dove, has also admitted he was wrong about inflation and made similar hawkish remarks. On Wednesday, the hawks went into action and raised the Fed funds rate by 50 basis points.
But the newly hatched hawks’ move won’t provide immediate inflation relief. The Fed still faces a monetary hangover that is entirely of its own making. Since February 2020, the Fed has flooded the “monetary bathtub” by increasing the M2 money supply by a cumulative 41 percent. Money has been flowing into the bathtub much faster than it is draining out of either the real GDP “drain” or the money-demand “drain.” When more money flows into the bathtub than drains out, money “overflows” as inflation.
At present, only roughly 25 percent of the money that has flowed into the tub since February 2020 has drained out to accommodate either the growth in real GDP or the demand for money, meaning that inflation will inevitably persist despite any hawkish action that the Fed now takes. So, the excess money in the bathtub (roughly 75 percent of the cumulative money-supply increase since February 2020) will overflow as inflation and will persist for at least the next two years.
Editor’s Note: This article has been corrected since its initial publication to reflect that Trump, not Biden, was in office at the onset of the pandemic.
Steve H. Hanke is a professor of applied economics at the Johns Hopkins University in Baltimore. He is a senior fellow and the director of the Troubled Currencies Project at the Cato Institute in Washington, D.C. Kevin Dowd is a professor of finance and economics at Durham University Business School in Durham, England.