Kevin Warsh Talks About Inflation the Right Way

T he new Federal Reserve has made a point of saying less, hoping that markets and economic data will start guiding the Fed rather than the other way around. In the last month, however, Kevin Warsh has had the opportunity to speak at length about inflation, both in his Jackson Hole address and in this week’s post-meeting press conference. It’s clear he thinks about the subject in ways that too few other monetary authorities do. As he would summarize his view, “Inflation is a choice.”

I’m not referring to Warsh’s assessment that current inflation remains elevated and persistent, or that it extends far beyond energy prices, or that interest rates must be raised in response (though I agree with all of that). He isn’t alone in those assessments; the Federal Reserve’s committee vote to hike rates on Wednesday was twelve to zero. Like Warsh himself, I want to focus here on the underlying principles: What is inflation? What causes it? How can it be corrected, and what trade-offs do those correctives require?

To most who speak on monetary policy, inflation is an unfortunate side effect of broader, mostly positive economic conditions. John Maynard Keynes, the prophet of economic management by a knowing government, believed inflation occurs when aggregate demand — the sum of all spending on goods and services — exceeds the productive capacity of a “fully employed” economy with no more idle resources to be put to use. Disciples of the Phillips curve — an observed inverse relationship between unemployment and inflation — later theorized that inflation results when a strong, tight labor market pushes up workers’ wages, forcing employers to raise their prices.

Both theories contain a good deal of truth. Individual prices are set by the intersection of supply and demand, so a rise in demand for certain goods can certainly increase their prices. Likewise, a constrained supply of a certain pool of labor can raise wages, pushing prices higher downstream to maintain businesses’ profitability. For example, semiconductor prices have skyrocketed because of surging demand to power artificial intelligence, and labor shortages are contributing to higher home-construction costs. Is that not what inflation is?

It took the rise of the monetarists in the mid-20th century, led by Milton Friedman, to make an essential revision to conventional wisdom. Yes, supply and demand factors certainly shape the prices of individual goods and services. Yet ironically, a wave of macroeconomists had disregarded a key macro factor. Inflation was not the rise of some prices, some of the time. It was a sustained, general increase in the average level of all prices across the economy. For markets to clear, such a phenomenon requires everyone to pay more for everything, on net, all at once. And that cannot happen without a greater total availability of money.

Higher demand here, tighter supply there — these are mechanisms for different prices to shift in relation to one another. Absent more dollars to spend all around, greater spending in one area must force less spending in another, resulting in lower prices to balance out higher ones, and eventually the movement of production to restore equilibrium. Americans can’t spend 30 percent more on gas, groceries, rent, and everything else if they have the same amount of money as before. Something would have to give.

Therefore, Friedman argued, the only thing that can cause genuine inflation is an increase in the overall money supply that outstrips production, enabling higher prices for everything at once. Under this formulation, inflation is not something that just happens in good times, during real economic growth or low unemployment, forcing the Fed to throw cold water on the party. No, inflation is caused by central bank policy that creates too much new money too quickly. The Fed isn’t the bouncer; it’s the bartender.

You will never hear Warsh talk about the economy as if it’s a car. He will never say that “the economy” — as in, a unified entity — is “overheating” or “running too hot” and that it needs to “cool off” or be “slowed down” to beat inflation. When he votes to raise interest rates, he doesn’t think they will help by putting people out of work or making them poorer. He does so because he understands interest rates correctly as the primary instrument by which the Fed influences the pace of new money creation, most of which occurs through banks lending out reserves.

As for the observed inverse relationship between unemployment and inflation, it’s probably a result of the fact that the spending of new money is initially perceived as a rise in authentic demand, prompting businesses to hire more. But Friedman predicted that the relationship was only temporary: Once monetary expansion bleeds into higher prices and wages across the board, the signal to expand dissipates. The stagflation of the 1970s proved him right.

In the long run, Warsh agrees with Friedman that there is no inescapable compromise between strong employment and stable prices. His colleagues’ error is to mistake transient corrections for permanent suppression. Growing up in the 1980s, Warsh saw that an economy with higher interest rates, falling inflation, and little guidance can do just fine.