What We’ve Learned About Inflation

As inflation eases, representatives of different schools of thought are taking victory laps. But who really deserves one? What have we learned about inflation?

I think the episode is a smashing confirmation of the fiscal theory of the price level. Where did inflation come from? Our government borrowed about $5 trillion and wrote people checks. Crucially, and unlike in 2008, there was no mention of how the new debt would be repaid, no promise of debt reduction later. The spending was couched as an “emergency expenditure” not going through the usual budget process or requiring offsets. Treasury Secretary Janet Yellen, argued that “with interest rates at historic lows”—they were then—debt isn’t a concern, so “the smartest thing we can do is act big.”

People could have looked at all this new debt, thought it would be repaid with interest, and therefore regarded it as a good investment. They didn’t. They chose to try to spend the new debt rather than save it. But we can’t all sell, so that drives up prices.

Inflation peaked in June 2022 and continues to ease, with interest rates below inflation until April 2023 and no recession. Why? Again, fiscal theory provides a straightforward answer. A one-time $5 trillion fiscal blowout causes a one-time rise in the level of prices, just enough to inflate away the value of the debt by $5 trillion. Then inflation stops, even if the Federal Reserve does nothing.

The Fed is still important in fiscal theory. The Fed bought about $3 trillion of the new debt and converted it to interest-paying reserves. Giving people checks backed by reserves is arguably a more powerful inducement to spend than giving people Treasury bonds. Now, by raising interest rates, the Fed lowers current inflation but at the cost of more-persistent inflation. That smoothing is beneficial.

These are core propositions of fiscal theory, stated ahead of time and at odds with conventional theories.

What of supply shocks, as espoused by “team transitory”—for example, Alan Blinder recently in the Journal? In this view, as Mr. Blinder describes it, “most of the rising inflation wasn’t due to an overheated economy fueled by monetary and fiscal policy, but rather to several ‘special factors’ that would disappear on their own. Principal among them were rising prices for food and energy and supply-side bottlenecks from the pandemic.”

There are two problems with this view. First, it confuses relative prices with the price level. If televisions are in short supply, the price will rise relative to other goods and wages. A supply shock can’t make the price of everything go up unless the government gives people enough money or debt to afford the higher prices. Second, it predicts that the price level, not the inflation rate, will return to where it came from—that any inflation should be followed by a period of deflation.

Monetarists also took a victory lap, noting the $4 trillion rise in M2 between the onset of the pandemic and inflation’s breakout in early 2021. This rise was almost mechanical: The Treasury deposited checks in people’s bank accounts, which are part of M2. After decades, M2 finally seemed to have something to do with inflation.

But does money alone drive inflation? Suppose there had been no deficit, and the Fed had done another $5 trillion of quantitative easing, buying $5 trillion of bonds in exchange for $5 trillion in reserves. Would people with $5 trillion more cash but $5 trillion less Treasury bonds, and thus no net increase in wealth, have tried to spend money, driving up prices? We pretty much know the answer—similar QE throughout the 2010s had basically no effect on inflation. In the monetarist view, more money and less bonds has exactly the same effect as more money and more bonds. In the fiscal view, overall government debt, including reserves, matters, not its particular maturity.

The Phillips curve remains the predominant mode of thinking about inflation, but this view has utterly failed. In this view, inflation is driven by output and employment. A year ago, a loud chorus said that inflation couldn’t be tamed without a recession, and without interest rates substantially above inflation, as in the early 1980s. Yet inflation has eased, with interest rates barely poking above inflation at all, and no recession in sight.

Witch hunts for “greed,” “price gouging” and “monopoly” have followed inflation for centuries. They too at best confuse relative prices for the level of all prices and wages.

A fiscal point of view isn’t encouraging about the future, however. Inflation is easing but remains high. The U.S. is running a scandalous $1.5 trillion deficit with unemployment at 3.6% and no temporary crisis justifying such huge borrowing. Unfunded entitlements loom over any plan for sustainable government finances. The Congressional Budget Office projects constantly growing deficits, and even its warnings assume nothing bad happens to drive another bout of borrowing.

Do people believe that the U.S. now can raise future taxes over spending by $1.5 trillion a year to finance new debt without more inflation? When the next crisis comes and Washington wants to borrow, say, $10 trillion for more bailouts, stimulus, transfers and perhaps a real war, will markets have faith that the U.S. can repay that additional debt? If not, another cycle of inflation will surely erupt, no matter what the Fed does with interest rates.

Mr. Cochrane is a senior fellow at the Hoover Institution, an adjunct scholar at the Cato Institute and author of “The Fiscal Theory of the Price Level.”