Simple & Tricky: Where Inflation Comes From and How to Fix It

So much for “transitory:” Inflation isn’t reverting to normal anytime soon. Although there were promising signs during the summer, new data show pricing pressures remain strong. The Bureau of Labor Statistics reports 8.2 percent year-over-year inflation for September. Core inflation, which excludes volatile food and energy prices, was 6.6 percent. Wages are growing at 6.7 percent, only now catching up with inflation. Households have suffered declining purchasing power for almost two years.

Preserving the dollar’s value is one of the Federal Reserve’s most important tasks. Our central bank has a mandate from Congress to pursue full employment and stable prices. Unfortunately, monetary policymakers are lousy at both. The Fed has been on the job for more than 100 years and still can’t get basic monetary policy right. We should seriously reconsider how much latitude we permit the Fed to police itself.

Inflation is tricky to predict yet simple to understand. It’s caused by too much money chasing too few goods. In the language of economics, the purchasing power of money falls whenever the money supply persistently outpaces money demand. This is precisely what happened over the last two years. In March 2020, the money supply totaled about $15.5 trillion. By the end of fiscal year 2021, it rose to $21 trillion—a 35 percent increase. Markets were certainly hungry for liquidity due to COVID-19-induced uncertainty, but the Fed’s monetary expansion far exceeded our appetites.

Other explanations for inflation don’t withstand scrutiny. Yes, the federal government ran massive deficits in 2020 and 2021: $3.1 trillion and $2.8 trillion respectively. But deficit spending by itself doesn’t cause inflation. If Uncle Sam consumes more of the economy’s output, someone else must consume less. The spending binge only became inflationary because it was supported by the central bank. Over that same time period, the Fed added $3.3 trillion in government bonds to its balance sheet. Monetary policy, not fiscal policy, is the determining factor.

Nor are global supply problems the primary culprit. To be clear, when supply conditions worsen, prices rise. But this is a secondary factor in the United States. Unlike in Europe, where the lion’s share of inflation can be explained by energy prices, American inflation is broad-based. Supply-side troubles make inflation worse, but price hikes would still proliferate without them.

Heed the Nobel laureate. The blame for inflation rests with central bankers. They are undoubtedly clever, credentialed, and compassionate. They unleashed the inflation conflagration nonetheless.

Milton Friedman said it best: Inflation “can be produced only by a more rapid increase in the quantity of money than in output.” Heed the Nobel laureate. The blame for inflation rests with central bankers. They are undoubtedly clever, credentialed, and compassionate. They unleashed the inflation conflagration nonetheless. It’s time to stop fiddling with personnel and focus on policy. We need major structural changes to the Fed to prevent this from happening again.

The Fed ultimately lacks discipline. Its authority derives from Congress, yet legislators have not provided concrete instructions. The dual mandate is pretty ambiguous. How much employment is “full” employment? How slow do prices have to rise to qualify as “stable?” Absent Congressional guidance, the Fed answers these questions for itself. Worryingly, this makes the Fed a judge in its own cause. “We investigated ourselves and discovered we did exactly what we were supposed to.” This isn’t a recipe for responsible policy.

Congress should step in to fix this problem. The Fed has the expertise to conduct monetary policy given some objective. It’s up to the representatives of the people to determine what that objective is. The best, and most likely, option is to focus on price stability alone. Employment is subject to a host of economic factors outside the Fed’s purview. The dollar’s purchasing power, however, it can control.

There are two leading options for a Congressionally imposed monetary policy rule. The first is a price level target: The Fed commits to keeping the value of money steady. The second is a nominal GDP target: The Fed commits to keeping total spending on final goods and services, what economists call aggregate demand, steady. Each has its merits. Dollar stability is great for long-term planning but could make the economy more vulnerable to supply-side holdups. Total spending stability is nimbler in the face of productivity changes, but the value of money is harder to predict over time. What’s important is that both rules can control inflation better than the highly discretionary procedures the Fed uses now.

There should be a lively public debate over the costs and benefits of each rule. But either rule is better than no rule at all. It’s clear the Fed, as currently constituted, is a poor steward of the dollar’s value. Let’s tell Congress to change that.