Only the Fed Can Create Inflation

R ecently, numerous economists have been forecasting a rebirth of inflation in the United States, depending upon the outcome of the election. These predictions expose the disastrous state of macroeconomics in the economics profession. 

Long after inflation had taken hold, the economics profession as a whole pretended that the dramatic increases in prices in these economies were “transitory,” or related to supply constraints. Too many economists failed to account for the fact that, in the U.S., a nearly 50 percent increase in the money supply occurred in the 16 months following early 2020. The fact that a massive increase in supply was going to lead to a fall in a price (in this case, of money, because inflation means that money is worth less) was something that eluded most economists. It is as if there were a massive increase in the supply of peanuts, relative to all other commodities, and economists were surprised to see the price of peanuts fall.

Regardless of who wins the election, excessive deficit spending and significant increases in our national debt will increase interest rates. Government deficits will not lead to inflation unless the Fed buys significant amounts of that debt, as they did from 2020 to mid 2022. As mentioned above, inflation is, by definition, a decline in the value (price) of money. The value of money, like most anything else, is determined by changes in supply and demand — not by what happens in some other market, like the labor market. If the Fed does not employ its balance sheet, there will be no inflation, but much higher interest rates. If the Fed does buy significant amounts of the debt, then indeed inflation will be the result (because it is “printing” money to do so). 

In either case, interest rates will increase. Why this is so difficult for so many economists to understand is something of a mystery. Academic macroeconomics models purporting to explain inflation either leave out the money supply completely, or keep the money supply in the model in a constrained fashion, so that the Fed can be assumed to focus only upon interest rates for monetary policy.

Inflation is a monetary phenomenon, not a fiscal phenomenon. If the Fed resists using its balance sheet, the higher interest rates caused by fiscal extravagance will create the conditions to alert politicians that unending deficits and roaring debt create higher rates. Fed purchases of government debt can keep those rates from rising — but only temporarily. In time, the resulting inflation, due solely to Fed expansion of the money supply, will cause rates to move higher. The Fed controls the money supply, not interest rates. Markets control interest rates. The Fed should get out of the way, and economists should get back to the basics of supply and demand.