According to the latest report on consumer prices, the cost of living in the United States has increased by more than 9 percent over the past 12 months—the fastest rate of inflation in more than 40 years. Where did all this inflation come from? Two types of government policies are candidates for blame. The first are fiscal policies, meaning expenditures authorized by Congress and approved by the president. The second are monetary policies, meaning the Federal Reserve’s interest-rate settings and bond-buying programs. But careful analysis reveals that, while both types of policies contributed to the recent rise in inflation, the Fed’s monetary policy has played the most critical role. This insight helps in finding a way to stop inflation without precipitating a severe recession.

Despite clear signs in early 2021 that the U.S. economy was rebounding strongly (albeit somewhat unevenly) from the spring 2020 Covid shutdown, one of the Biden administration’s first major policy actions was to secure the passage of the American Rescue Plan Act of March 2021, which authorized more than $1.9 trillion in new government spending. Later, the Infrastructure Investment and Jobs Act of November 2021 added another $1.2 trillion in spending. To put these figures in perspective, GDP—the total dollar volume of income and spending in the U.S.—was nearly $23 trillion in 2021. The cost of these two spending programs, therefore, totaled about 13.5 percent of GDP—a massive intervention in the private economy.

Meantime, the Federal Reserve held interest rates at exceptionally low levels— close to zero—throughout all of 2021. From January through November, the Fed supplemented its zero-interest-rate policy with large-scale purchases of U.S. Treasury and U.S. government agency mortgage-backed bonds at a pace of $120 billion per month. Only in the last two months of the year did the Fed finally begin to taper—that is, to reduce gradually the scale of—its continuing asset purchases. The combined effect of these monetary policy actions was to increase both the monetary base (currency plus bank reserves) and the broader M2 monetary aggregate (currency plus checking- and savings-account deposits) by more than 20 percent over the 12 months ending December 2021.

The timing, as well as the colossal size, of the March 2021 fiscal stimulus package makes it tempting to jump to the conclusion that it, more than anything else, drove inflation sharply higher. Contributing further to this impression, some of the most highly publicized components of the package took the form of direct payments to individuals and extended unemployment benefits. These payments resemble the “helicopter drops” of newly printed money that many economists, including Milton Friedman, would use to consider in theory the inflationary effects of an increase in the money supply.

But can fiscal policy, by itself, create such effects in practice? The answer is no. To understand why, suppose first that the stimulus payments to individuals, together with the rest of the March 2020 spending package, had been financed directly out of current tax revenues. In this case, it’s clear that the spending would simply be transferring wealth from one group, taxpayers, to another, recipients of government-dispersed funds. In the aggregate, there would be no increase in the money supply and thus no reason to expect that higher inflation would follow. Now suppose that the recent fiscal stimulus was financed not through taxes but instead through government borrowing. But let’s also suppose that the Fed had suspended its bond-buying programs entirely by March 2020. Without the Fed’s help, the private sector would have had to absorb all of the newly issued Treasury debt. Even as the fiscal stimulus would have added funds to some people’s bank accounts, the government bond sales would have drained funds from the accounts of those buying the bonds. In the aggregate, once again, there would be no increase in the money supply and no reason to expect higher inflation.

To be sure, fiscal policy played a supporting role by requiring the Treasury to issue new bonds, but inflation wouldn’t have risen to its current heights without the Federal Reserve’s actions—that is, without monetary policy. This is what Friedman meant when he wrote in 1970 that “inflation is always and everywhere a monetary phenomenon in the sense that it can be produced only by a more rapid increase in the quantity of money,” before going on to acknowledge that “there are many different possible reasons for monetary growth, including . . . financing of government spending.” Excessive monetary expansion is a necessary condition for inflation. Without it, sustained inflation cannot occur.

These observations point to continued monetary-policy normalization as the key to ending today’s inflation. Appropriately, in 2022, the Fed has changed course and acted decisively to bring inflation back under control. It has already wound down and even started to reverse its bond-buying programs. It has raised interest rates aggressively and made clear that additional and possibly substantial rate hikes are still forthcoming. These are the right moves.

Of course, higher interest rates will also slow the rate of economic growth and raise the possibility of recession. Here, again, fiscal and regulatory policymakers could play a positive supporting role by asking how they can help offset the drag imposed by higher interest rates: perhaps by making it easier for displaced workers to reenter the labor force and for new and existing businesses to grow and create more jobs. But regardless of which priorities the administration and Congress decide to pursue, the Fed —and the Fed alone—must lead the way in restoring price stability.

Photo by Mark Wilson/Getty Images


City Journal is a publication of the Manhattan Institute for Policy Research (MI), a leading free-market think tank. Are you interested in supporting the magazine? As a 501(c)(3) nonprofit, donations in support of MI and City Journal are fully tax-deductible as provided by law (EIN #13-2912529).

Further Reading

Up Next