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Understanding Recent US Inflation

Although US monetary policy was too aggressive for too long, the likely culprit behind the recent surge in consumer prices was an extraordinarily expansionary fiscal policy. After all, the Great Recession was also met with an aggressive monetary-policy response, but inflation barely budged for a decade.

CAMBRIDGE – When considering what caused the sharp increase in the US inflation rate from late 2020 to today, my initial instinct was to focus on aggressive monetary policy, following Milton Friedman’s famous dictum that, “inflation is always and everywhere a monetary phenomenon.” But while monetary policy is important, aggressive fiscal policy may have been more important this time.

From March 2020 to March 2022, the US Federal Reserve kept short-term nominal interest rates at zero while also using quantitative easing to expand its balance sheet from $4 trillion to an eventual $9 trillion. It is now generally acknowledged that the Fed was way behind the curve after late 2020, if not earlier. Because it did not raise its policy rate until the spring of 2022, it failed to keep nominal interest rates ahead of inflation, and thus lost control.

The problem with arguing that monetary policy was the sole source of the recent inflation is that the Fed was similarly aggressive during the Great Recession and its aftermath, from 2008 onward. Short-term nominal interest rates were fixed at zero for what turned out to be a seven-year period (early 2009 to late 2015). The Fed’s balance sheet grew from $900 billion in August 2008 to more than $4 trillion – which seemed like a big number at the time. Yet inflation remained tame – averaging around 2% per year from 2009 to 2019 – and inflation expectations remained anchored at about the same value.

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