Hudson Institute

A Rotten Money Regime is Responsible for Pandemic and War Inflation

federal reserve inflation
Renovations continue on the Marriner S. Eccles Federal Reserve Board Building on September 19, 2022, in Washington, DC. (Kevin Dietsch/Getty Images)

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Who is responsible for the Great Pandemic and War Inflation of 2021–22? Is it Federal Reserve Chair Jay Powell, former President Donald Trump, President Joe Biden, or President Vladimir Putin?

The answer is that the buck stops at a rotten monetary regime—the so-called “2-percent-inflation standard.” Trying to blame particular individuals may help those who gain from the present monetary status quo. Yet blaming them absolves the monetary regime, which is trampling upon the green shoots whose growth is essential for the renaissance of competitive free-market capitalism.

If the United States had a good money regime when first the pandemic and then the Russian war struck the economy, the great monetary inflation that these shocks spawned would not have occurred.

The current money regime might well have done better with more capable leadership and good luck—but the regime’s deep flaws prevented the possibility of an overall good outcome.

Furthermore, even if the pandemic and war had not struck, the bad money regime was producing bad outcomes—including economic sclerosis with sluggish growth rates for productivity and living standards while advancing monopoly capitalism. These outcomes could well have gotten a lot worse..

This policy memo focuses on the shocks of the pandemic and war rather than what could have happened without them. However, it does venture into the counterfactual of how a good money regime would have responded to those shocks, while helping demonstrate what has gone wrong.

Demonstrating the links between the rottenness of the monetary system and the high inflation during the pandemic and Russian war requires sharing with the reader a preview of the differences between good and bad money regimes. A broader analysis of these should follow in subsequent policy memos.

The 2-Percent-Inflation Standard Regime

The monetary regime on the eve of the pandemic and still in place can be described as “the 2-percent-inflation standard.”1 In the US and Europe, that regime has been in power since the end of the twentieth century.

Central banks following the Fed’s example profess that they aim for price stability, by which they mean keeping inflation at 2 percent per annum. In the US, Congress has implicitly endorsed the standard by confirming presidents’ appointments of top Fed officials who respect the standard fully or who played a big role in its initial design and implementation.

An “emperor’s new clothes fable” seems to magically underpin the regime.

Specifically, in the standard’s heyday—whether we define this as the decade of “Great Moderation” leading up to the Great Financial Crisis of 2007–09,2 or all the way through to the pandemic—most of the public and indeed most experts exuded confidence in the aim of their well-intentioned central bankers. Yet the public, experts, and central bankers did not engage in a dialogue that spelled out in any convincing fashion what would guarantee success.

Ostensibly, monetary policymakers are armed with a high-powered econometric model that links such variables as estimates of the “natural rate of unemployment” and “neutral interest rate.” No one from the Fed chair down has any confidence in those estimates. And there is much “black box mystery” about how this model will guide central bankers as they continuously try to achieve 2 percent inflation (as expressed usually for a two-year period ahead, continuously rolled forward).  

According to the regime theorists,3 policymakers can achieve this aim by piloting a very short-term interest rate under the central bank’s command (in the case of the US, the rate paid overnight on federal funds). Non-conventional tools—including quantitative easing (or QE, which is when a central bank effects a “shock and awe” increase in the supply of its reserves, a key component of the monetary base, usually by purchasing securities with money it creates), quantitative tightening (or QT, which is when a central bank reduces the supply of its reserves), and manipulation of longer-term interest rates—can on occasion supplement such piloting. (One key form of manipulation is forward guidance as to the central bankers’ intentions with respect to the short-term policy rate.)

Bad Regime vs. Good Regime

The 2-percent-inflation standard does not fit the definition of a “good money regime.” Missing from the standard is an essential characteristic of good money—a control system, otherwise described as a “solid anchor,”4 which operates directly on the supply of money.   

The anchor prevents the supply of money from veering ahead of the demand for money on a sustained basis. A free market determines interest rates, both for short and long maturities, without any pegging. In this regime most expect that money will retain its purchasing power over the very long run.

Yes, under the good regime, prices would rise or fall for sustained periods. In the long run, though, a solid anchor would ensure that these periods would most likely offset each other, albeit not in a predictable fashion (in that the periods would be irregular and of variable length).

These fluctuations of prices upward and downward can be described as the “natural rhythm of prices.” This rhythm is crucial to monetary stability and the well-being of a free-market capitalist economy. Examples of natural rhythm include falling prices during a period of an economic miracle (e.g., a spurt of productivity growth) and rising prices during a period of resource shortage or dislocation (e.g., a supply shock in a war or pandemic).

Monetary authorities who suppress such a natural rhythm of prices risk creating monetary disorder. For example, they can create asset inflation or asset deflation. Asset inflation can occur when authorities bear down on interest rates, especially the long-term interest rate, as the natural rhythm of prices moves downward in an attempt to prevent inflation from falling below their target.

Because central bankers have been following a bad money regime before the shock of a pandemic and war, everything was not well before these events, as the next section shows.

How a Bad Regime Generated Economic Sclerosis

Through the second decade of this century, monetary inflation produced severe economic sclerosis, a disease that saps the dynamism of free-market capitalism. In many areas of the economy, other than in venture capital for the tech sector, long-run gestation investment ran at an abnormally low level.

Individuals followed investment strategies based on financial engineering. A key component of this is camouflaged leverage; the creator of a financial product extols its likely high returns that are in fact founded on intensive debt financing, hidden at least partially from the casual viewer. Critics argue that some private equity products fall under this description. In general, a business that focused on long-gestation investment did not appeal to these investors. They eschewed gambles whose payoff depended on an eventual day of reckoning (e.g., a market crash or great recession) coming after heavy capital spending produced the bulk of their returns.

Crucially, monetary inflation policies characterized by low interest rates and asset inflation advanced monopoly capitalism. As digitalization spawned winner-take-all advantages in emerging technology platforms, monetary inflation added fuel to the fire. Yield-hungry investors piled up on stocks that had any realistic prospect of generating monopoly rents in the future, and the high price of their equities meant that they could finance predatory practices. Whether these practices were aimed at vanquishing actual or potential competitors, they undermined the dynamism of free-market capitalism.

Under a bad money regime, policymakers are incessantly active. There is no anchoring system as there is under a good money regime in which automatic mechanisms keep the machinery of money under control.

How Bad Money Regime Responded to the Pandemic

When the pandemic struck in the winter of 2020, the Fed, working closely with the Treasury Department, decided to revise its interest rate policy. This rate was fixed at zero, and Fed Chair Powell clarified that he and his colleagues would not think about raising it for a long time. Meanwhile, the central bank deployed non-conventional monetary tools, including most ostensibly QE.

With these actions, the Fed sought to prevent an immediate financial crisis, provide smooth financing for the federal government’s massive emergency borrowing, and fight the perceived danger of an economic depression, all while assuring everyone that it was still fully respecting the 2-percent-inflation standard. Policymakers both inside and outside the Fed made clear that they were fighting the danger of financial and economic collapse, evoking the Great Recession of 2008–09.5

Their fight continued well beyond the end of the immediate pandemic economic spasm of spring 2020. As consumer prices started a steep climb through the second half of 2021, Fed officials from the chief downward assured all that this climb was “transitory.”

According to monetary policymakers, supply shortages and disruptions could cause inflation to rise above 2 percent, even by quite a lot. But as shortages and disruptions eased, inflation would come back down to 2 percent.

Both of those assertions contained large errors of thinking and action.

How the pandemic caused economic activity to stop or spasm is different from normal business cycle recessions. These are almost always brought on by the operation of monetary forces and feature a sustained pullback in the supply of credit. By contrast, in a pandemic economic spasm and its aftermath, economic weakness stems from the fact that economic activity across a wide area of products, services, and labor markets seize up due to the medical danger. Yet a sharp economic rebound after the spasm was plausible and indeed likely, especially if vaccines and cures emerged quickly.

Though the National Bureau of Economic Research (NBER) categorized the two-month span of February to April 2020 as a recession, monetary policymakers should offer a more nuanced judgment. In treating the pandemic seize-up of economic activity as a severe recession, they failed to take note of key distinctions.

While automatic mechanisms in a free-market economy can spur a recovery after normal recessions, in the case of a pandemic spasm, these are supplemented by important forces as described above. But Fed officials instead sent messages about how the high inflation that emerged in the second half of 2021 was transitory and would come down without any action on their part—meaning that they would not raise interest rates from zero early or stop the massive monetary expansion.

Pandemic Rise in Prices Is Natural, but so Is a Subsequent Fall

Under a good money regime, the price of some goods and services would likely climb to levels far above normal during a period of shortage and dislocation. The average of consumer prices would also reach an abnormally high level, consistent with what this memo earlier described as “the natural rhythm of prices.”

Real incomes in aggregate would fall in step with the shortages. That fall would have curbed any rise in the demand for money despite the rise in transaction prices. Hence, a present rise in prices (in accordance with the natural rhythm) would have been consistent with a money supply that was only rising slowly (as it would in a good money regime).

Crucially, under this good money regime most people would expect that the shortages and dislocations would eventually resolve themselves and that prices would fall back down.  Automatic monetary mechanisms underpin that outcome. Specifically, as real income in aggregate recovers in line with receding dislocations, demand for money would rebound;  monetary conditions would tighten accordingly, given a continuous effective constraint on money supply growth. In the long run, the purchasing power of money would be unchanged.

That scenario is very different from what the Fed and other central banks promised under their bad money regime. Under this policy, inflation would eventually fall to 2 percent per annum, but the purchasing power of money would not recover (i.e., there would be no fall in prices) to compensate for the loss (rise in prices) that occurred during the pandemic and war.

Indeed, if people expected money’s purchasing power to recover, as it would under a good money regime, the economy could have rebalanced better during the pandemic, which did not happen under the bad money regime. A wide range of spenders, including households and businesses, would have realized that high prices were transitory, and they would have delayed purchases until sometime in the future when prices would fall. There would be no need for interest rates to rise far above normal to disincentivize present spending.

This is light years away from what happened.

Bad Regime Means that Pandemic Price Rises Are Not Transitory

Under the 2-percent-inflation standard, pandemic price rises cannot be transitory. And any pause to monetary inflation, such as when the Fed takes a hawkish turn and raises interest rates in response to political alarm about high inflation numbers, is only transitory.

The Powell Fed, operating in accordance with regime principles, has not signaled any intention of conducting monetary policy in a way that would allow prices to fall in the future. Rather, the hump of prices that reflected dislocations and shortages would be followed by a gently sloping upward hill.

In this way, the Fed became an agent of the government by levying an inflation tax (i.e., the real value of money and government bonds would fall—any interest income on the latter would fail to discount the erosion from inflation).6 Unlike in the case of a good money regime, the loss in the purchasing power of money during the rise of prices to the hump would not be recouped later.

In effect, by making clear that there would be no ultimate fall in prices, the Powell Fed announced a policy of deliberately inducing monetary inflation. Moreover, the monetary inflation proved powerful enough not just to prevent an eventual fall in prices back to the base but also to cause prices to increase further even as shortages decreased.

Vast Collection of Inflation Tax—Deliberate or a Blunder?

Was the further stimulus of monetary inflation, which fueled Big Government’s inflation tax, deliberate or a mistake?  

If we take Fed officials at face value, their stimulus of inflation was not deliberate; they believed their forecasts throughout 2021 that inflation would fall to 2 percent the following year. If there was an element of deliberation, it was in terms of the risks that Fed policymakers (and the political forces to which they responded) were prepared to take.

Senior Fed officials and those they answered to surely did not have 100 percent confidence in the forecasts. Both groups must have realized there was a chance that their policies were inducing severe monetary inflation. They did not think that this scenario was the most likely case, but they were prepared to live with it. Why? There is a range of possible answers.

One would say that Big Government may have recognized how an inflation tax could reduce the real value of its mega debts. Meanwhile, a newly elected administration, which intended to embark on a mega-spending spree, may well have reckoned with an accommodative Fed whose president’s term was up for renewal by January 2022.

The Fed justified its accommodation, without describing it as such, by claiming in 2021 that it had no evidence of monetary inflation and that goods inflation was transitory. It also said that aggregate real demand, as tracked statistically in real GDP data, barely went above pre-pandemic levels.

This memo has already dealt with the transitory claim, but other parts of the Fed’s claims need examination.

The Fed based its continuing monetary stimulus through the first two years of the pandemic on the implicit hypothesis that “aggregate demand” in the economy had fallen well below “aggregate supply.” Comparing real demand to real supply is hardly a reliable basis for assessing inflation pressures.

How much supply potential had changed and in what ways during the pandemic is unknown. And the manic bunching of demand in particular sectors—whether stay-at-home technology, the construction of residences away from traditional metropolitan areas offering more space, consumer durables generally, and then most recently a fantastic revving up of demand for air tickets—these were all surely symptomatic of some monetary malaise.

Bad Money Regime Ignores Money and Asset Inflation

Monetary inflation is ideally measured by how much the supply of money veers ahead of the demand for money.

But in the current bad money regime, there is no basis for assuming a strong, broad, and stable demand for money, most importantly for a monetary base that is directly under the central bank’s control. (Indeed, the Fed’s practice since late 2008 of paying interest on bank reserves, a main component of the monetary base, has totally destabilized demand for this aggregate.)  So policymakers become hooked on a range of unsatisfactory alternatives.

Even so, the extent and virulence of asset inflation during the pandemic’s great rebound should have been a warning sign.

Symptoms of asset inflation included fantastically hot temperatures in a range of asset markets. For example, the pandemic seemed to drive profits higher for some technology companies (pandemic stocks acted like war stocks in wartime); cause a boom in financial engineering (including camouflaged leverage) and carry trades, especially into high-yield credit; and spark speculative mania. Residential real estate markets caught fire. Currency markets told a story of monetary malaise. A sometime tell-tell sign of monetary inflation was evident through the early stages of the pandemic—a big depreciation of the US dollar (this started to reverse in the second half of 2021 as speculation began to form that the Fed would become more hawkish going forward).

Policymakers of the US money regime, the 2-percent-inflation standard, from Alan Greenspan and Ben Bernanke onward, entirely reject the concept of asset inflation. (Albeit, Greenspan had some initial concerns about “bubbles,” as illustrated by his musings about “irrational exuberance” in late 1996.7 Some of these officials are on the lookout for today’s complex asset markets veering into speculative disorder and using monetary tools against this8—but they seemed not to have any inkling of these problems during the pandemic.

Hypothetical Good Policymakers in a Bad Regime

How should have good policymakers who are within the bad money regime of the 2-percent-inflation standard responded to the explosion of the federal deficit during the pandemic?

In principle, good policymakers should realize that, insofar as huge government payments made households feel better off despite the less productive economy (real output diminished due to the pandemic), this policy meant that markets should adjust with higher interest rates when there is no monetary inflation.

Much would depend on individuals’ expectations for their taxes. If in general households realized that future tax burdens in all forms, including monetary taxation, would rise to pay for the transfers, then the increased spending overall could be limited (though some households would be up, and some would be down).

But there was no such messaging about future tax burdens. Administration officials did not in any way hint at a “solidarity tax” in some form after the medical emergency.

Even so, blaming inflation on fiscal policy without identifying the monetary fault is always lame.

Under a good money regime, interest rates would respond freely as part of a wider monetary reaction to big spending impulses stemming from fiscal excess. The Federal Reserve had absolutely no inclination to act in that way.

If the Fed had driven up interest rates and told markets that it would not levy a monetary inflation tax, it would have risked precipitating a default crisis in government debt as its credit rating slid. Congress may have hauled Fed officials over the coals—and the Fed president could say bye-bye to any hopes of being renominated by the White House, let alone getting any such renomination through a hostile Congress.

A Hypothetical Good Regime Response to a Pandemic

In contrast, how might have a good money regime responded to the pandemic shock, and subsequently to the shocks related to the Russian war?

Under this good money regime, the federal government’s scope, as already discussed, to unleash huge spending interventions in the economy without a parallel levying (at a pre-announced date in the future) of a solidarity tax would have been limited by a potential default crisis.

The market would have determined interest rates. There is no reason to think that short-term rates would have collapsed to zero.

In a good regime, rates are determined in overnight markets for money where banks compete for scarce reserves that pay no interest. These reserves and other forms of monetary base (especially cash) are very much sought after for their super-money qualities relative to other forms of money.

The overall supply of the monetary base grows very slowly. Under such a regime, short-term rates could rarely, if at all, fall below 1 percent (such was the case with money rates in London during the many decades of the international gold standard).

Millions of savings-investment decisions at a micro-level determine long-term rates under such a regime. On this micro-level, individuals have information about investment opportunities and trade-offs between present and future consumption. Such information is not available to the purveyors of even the most super econometric model.

Would the onset of a pandemic have sent long-term rates up or down? It is of course impossible to answer that question.

Though, we could imagine that those households and businesses facing likely transitory dips in their income through the period of medical emergency would have been dis-savers—either running down savings or borrowing. Some of this dissaving would have been done through the intermediation of government (issuing debts to hand out grants to help those so afflicted). On the other hand, the state of investment opportunity as aggregated over so many individuals is impossible to assess.

We could say that expectations that the prices of goods and services on average would fall later after the present run-up to a hump during the shortages. This would have meant that long-term rates in real terms would have been higher than in nominal terms, so the actual climb in nominal rates reflecting any net new shortage of savings relative to investment or government borrowing would have been much less than what occurred under the bad regime.

As this memo has already explained, prices of goods and services overall would have risen to a higher-than-normal level during the pandemic. Meanwhile, people would have expected a subsequent relapse toward normal prices sometime in the future. There would not have been asset inflation and the associated widespread malinvestment.

Add Russia’s War into the Inflation Mix

So far, the analysis here has focused on the pandemic and the monetary response.

The economic war between the US and its allies on the one hand and Russia on the other unleashed further supply shocks.

A primary shock emanated from Western Europe importing less of its oil and gas from Russia and more from the US and Middle East. The neutral world by contrast started to import less energy from the US and Middle East and more from Russia, obtaining their supplies (most of all oil) at big discounts.

As a consequence, Western consumers faced a price shock (as did Japan, to the extent that it joined this shift, with the evident exception of imports from Sakhalin and its own domestic supplies of hydroelectric and nuclear power). In addition, there were restricted supplies of agricultural goods and other commodities that came from the Black Sea area. There was also a surge in demand globally for military equipment—a large part of this came in the form of US exports to NATO allies who in turn exported older hardware to Ukraine, but it also came from direct transfers to Ukraine and heightened demand from now more anxious governments worldwide.

In principle, all of this could be seen as a positive income shock for the US, given its role as a major producer and exporter of energy, food, and armaments, offset to some degree by the negative effect of higher energy prices on many US consumers. In Europe, by contrast, with the obvious exception of Norway, these developments were in a clearly negative direction for aggregate real incomes. European governments would respond by borrowing to aid consumers and businesses. The rotten European monetary regime would facilitate the government borrowing to some inflationary degree.   

Bottom Line

Under a good money regime in the US, consumer prices would have ascended into a mountain range from level ground, reflecting the scarcities and disruptions of the pandemic and war. There would have been firmly grounded expectations, however, that prices would come back down to around the same level ground in the long run on the other side of the mountain range. This journey to, through, and beyond the mountains would have been steered by an automatically operating anchoring system intrinsic to the good money regime.

By contrast, under the bad money regime of the 2-percent-inflation standard, once prices reach the mountain range, which towers much higher than under the good money regime, they can only find rest in the form of an upward-sloping plateau.

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