As Americans know all too well, inflation surged dramatically in 2022 and 2023 following the worst of the COVID pandemic. The Federal Reserve responded with a rapid series of rate hikes that drove up the cost of mortgages and other loans to levels not seen since the 1990s. The growth in prices has moderated substantially since then and Fed Chair Jerome Powell recently announced that the Fed could begin to lower interest rates as soon as September if inflation is moving “sustainably” toward its 2% target.
In this Q&A, John Cochrane dives deep into our unusual inflationary times. Cochrane is an economist at Stanford’s Hoover Institution and a professor of finance and economics (by courtesy) at Stanford Graduate School of Business. He is also a senior fellow at the Stanford Institute for Economic Policy Research, the author of The Fiscal Theory of the Price Level, and writes a newsletter titled The Grumpy Economist.
In a recent paper in the Review of Economic Dynamics, Cochrane argues that higher inflation resulted from the federal government pouring trillions of dollars in stimulus spending into the economy during the pandemic. To prevent future inflation shocks, he says U.S. policymakers must target taxes, spending, and growth and stop relying on rate-setting alone to keep the economy in check. “The Fed is a lot less powerful than people think,” he says.
What do you think is behind the pandemic-era burst in inflation and its recent moderation?
John Cochrane: In my analysis, inflation mostly came from the government’s $5 trillion in COVID and post-COVID deficits. The government essentially sent people $5 trillion with no plans to pay the money back. People tried to spend it, driving up prices. The Fed eventually raising interest rates made inflation come down a bit faster than it would have otherwise, but it was going to go away on its own anyway. There is no magic momentum to inflation. Stop pushing, and it stops.
You argue that higher inflation did not result from the Fed’s efforts to buy up $4 trillion in government debt from banks during the 2010s, known as quantitative easing (QE). Doesn’t this run counter to conventional economic theories?
From 2010 to 2019, the government bought $4 trillion of bonds and issued $4 trillion of new money in return. Those transactions had zero effect on inflation, which just trundled along a bit below 2%. Then from 2021 to 2023, the government borrowed $5 trillion, and sent people checks. This time, the Fed bought about $3 trillion of the new debt and issued new cash to banks. In this second scenario, we got huge inflation. I think the lesson is pretty clear — it’s the big deficit that caused the inflation, not primarily whether the Fed buys Treasury debt and gives bank reserves in return.
Money is just another kind of government debt, after all. QE is taking a $20 bill and giving back two fives and a ten. Getting change for the $20 is not going to make people spend a whole lot more. Deficit finance is just giving people $20. Whether they get the $20, or two fives and a ten, doesn’t really matter. They spend it.
I should clarify in all this: debt and deficits alone do not cause inflation. Governments often borrow, spend, and don’t produce inflation because they have credible plans to pay back the debt. Government borrowing in crises can be a great and good thing. If you get a $20 bill as well as news that taxes go up $20 tomorrow, you save the $20 and there is no inflation. It’s pretty central that there really was little talk about how the big deficits of 2020–2022 would be paid back.
Was the Fed too slow in responding to rising inflation in 2021?
Yes. Not even in the 1970s did the Fed wait an entire year to move interest rates after inflation surged.
The temptation has been to set interest rates using a simple, preannounced mathematical formula, such as the Taylor Rule, which says that central banks should raise interest rates when inflation increases and lower rates when GDP declines. Does the U.S. need to rely more or less on predictable rules in the future?
Rules have always been attractive and always contentious. The Fed feels that by looking at everything, it can surely do better than following a rule. Critics say that looking at everything has just distracted the Fed and led to many past mistakes. Rules are helpful to guide people’s expectations and let them plan better. A rule makes the Fed’s actions more predictable. And more boring. A Fed chair who just implements a rule can’t be the master of the universe.
I think the Fed should not mechanically follow a rule, but rather use rules as a benchmark. Then explain what’s special today that motivates deviating from the rule. Yes, look at inflation and employment, but don’t ignore a huge war, financial crisis, or cyberattack. This is John Taylor’s interpretation of the rule, and I largely agree.
The liberal economist Paul Krugman agrees with you that runaway inflation didn’t follow from setting interest rates at zero for decades and that the Fed probably engineered a “soft landing,” which you predicted in 2022 as well. Do you two agree often?
If we come to the same answer, it is from a totally different background. We fundamentally disagree on the cause of inflation. He backed the “supply shock” excuse and predicted it would be “transitory.” Supply shocks are relative price movements, not inflation. He’s been all for fiscal stimulus. I think the fiscal stimulus caused the inflation. So there is still plenty to disagree on.
The current speculation is that Fed Chair Powell could start to lower interest rates to stimulate the economy right before the election. As monetarists like Milton Friedman have asked, can the Fed be trusted to set interest rates in a nonpolitical way to fight inflation?
I don’t think the current Fed does any tinkering of interest rates to affect elections. The Fed is a political body, however. The Fed was set up by Congress, which wanted it a little bit independent and a little bit responsive to political needs. Remember, we live in a democracy, not rule by unaccountable unelected technocrats. A bit of responsiveness to the people’s elected representatives is not a terrible thing. The Fed’s nods to climate, its move to worry about inequality, and its constant protection of the banking industry do represent a bowing to politics. If Congress wishes to have a more independent central bank, it can set up the bank with more independence.
You argue that monetary policy may be “just a carrot in front of the fiscal horse that pulls the inflation cart,” with fiscal policy mainly responsible for the recent bout of rapid inflation. Why do you say that coordinated action is necessary on both the fiscal and monetary fronts?
The Fed alone cannot stop all inflation. The Fed is a lot less powerful than people think. Our fiscal situation is in really bad shape. Markets expect Congress to fix it after they’ve tried everything else, but eventually people will lose faith. I also fear that the next crisis will be like the last one, but bigger. In the next crisis, the government will want to borrow and print maybe $10 trillion to bail out the financial system again, keep businesses and people afloat, and maybe finance a war. But since everyone saw how things turned out last time, we’ll get a big inflation fast. Or a debt crisis, or a default. It can happen, even in the U.S. Then the U.S. can’t borrow enough to meet the needs of the crisis, a genuine catastrophe.
With payments on the U.S. federal debt already at historic levels, most economists surveyed by the Wall Street Journal in July predicted that inflation, budget deficits, and interest rates would be higher under a second Trump administration. What’s your view of the future of inflation if Trump or Harris were to win the election?
I don’t see a big difference between the parties in terms of inflation. Democrats will tax more, spend more, and rack up huge deficits. They’ll hobble traditional energy businesses, throw money down supposedly green protectionist ratholes, and encourage immigration. Republicans will tax a little bit less, spend a little bit less, deregulate a bit, impose tariffs, throw money down other protectionist ratholes, and rack up huge deficits.
The important part of all these policies is how much they raise or lower overall economic growth. They really are not about inflation.
This interview has been edited for length and clarity.
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