There has been a rousing debate going on in the last couple of years about the source of the recent round of inflation in the U.S. John Cochrane just posted a summary of his remarks at this year’s ASSA meeting to his Substack page. It was a true all-star session with Ben Bernanke, Christy Roemer, and John. The video of the full session can be found here.
John described three puzzles with regard to our recent bout with inflation: i) Why did inflation break out suddenly in February 2021? ii). Why did inflation peak, and then ease starting in June 2022, while the Fed Funds rate was still 1.5%, with no unemployment or recession, and no repeat of 1982? and iii) Why is inflation stuck around 2.5%? He illustrates these puzzles with this terrific graph:
He provides an interesting analogy to explain the patterns shown in the graph. Specifically, he argues that what happened is equivalent to the inflation that often has followed the debt financing of wars in the past:
In a war, governments spend like crazy. Central banks monetize debt, and hold interest rates down. Inflation predictably breaks out, creating a Lucas-Stokey state-contingent default. Holders of outstanding bonds pay for a lot of the war spending. That’s exactly what happened. The primary deficit touched 25% of GDP. Government debt in private hands rose $5 trillion during Covid, and another $4 trillion since. The Fed monetized $3 trillion of that debt, and kept interest rates at zero for an unprecedented year even as inflation surged. Borrow and print money, send people checks. Is it a mystery why we had inflation?
So, in John’s telling, the Federal government AND the Federal Reserve Bank (FED) were jointly responsible for the 2021-2024 inflation. However, this time the war was against COVID rather than other countries. The starting point was the blizzard of Federal spending in response to the COVID pandemic economic slowdown. The FED then expanded the money supply in parallel to accommodate the fiscal stimulus. The net result was a roughly 20% increase in the average level of prices in the U.S. economy. The big losers in this game (as it has always been) were bondholders, who took a staggering $3 trillion haircut on the real value of their investment. This is what economists call “monetizing the debt” in living color.
But as we economists also like to say, “there are no free lunches.” There is likely to be a price to be paid regarding our ability to respond to the next crisis. Will we see a return of the “bond vigilantes” of the 1990s? These vigilantes had strong memories of the 1970s inflation and did not want to be fooled again. My guess is that something similar could happen going forward. I know I will think twice about buying and holding long-term fixed-rate bonds in the future.
Laurence J. Norton Chair of Agricultural Marketing
University of Illinois at Urbana-Champaign
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This is a simple but very accurate account of what transpired. It is good reading. Your “guess” about bond holders seeking less duration is spot-on. We do not have a fortune in Government securities, but we moved most of it out of Bank CD’s due to low interest rates and put it in Treasury Bills which have maturities of one year or less. I agree that duration is not your friend in Government securities.