The Fed Wasn't Responsible For Surge In Inflation, But Is Likely To Create Recession

May 25, 2022 4:32 AM ET16 Comments


  • No matter how extravagant monetary policy is, as long as it doesn't produce a credit boom, it doesn't increase the money supply and hence inflationary pressures except in asset prices.
  • Fiscal policy becomes very powerful at very low interest rates and can produce more useful economic outcomes than rising asset prices as the pandemic relief demonstrated.
  • However, the pandemic stimulus was a one-off and fiscal policy is already contractionary, so it's not the main driver of the present inflationary climate.
  • Supply chain issues have been enduring and even worsened, and central banks are ill-equipped to deal with these, rising the risk they'll overshoot with monetary tightening.
  • Looking for a helping hand in the market? Members of SHU Growth Portfolio get exclusive ideas and guidance to navigate any climate. Learn More »

Federal Reserve Bank of Chicago

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With inflation in the US at 40-year highs, there is panic in the markets that the Fed is way behind the curve and will slam the brakes so hard as to snuff out the recovery and plunge the US economy into a recession.

Larry Summers, the former Treasury Secretary under Clinton, and well-known economist, was early to the danger of inflation spiraling out of control and he argues that there's never been a moment when we had inflation over 4% and unemployment below 4% when we didn't have a recession within the next two years.

He may very well be right again, but before we go into that, let's look at what actually caused this great surge in inflation, which is something we haven't seen for 40 years. Basically, there are three competing, but by no means mutually exclusive theories:

  • Massive monetary easing
  • Massive public spending for pandemic relief
  • Supply chain and labor market disruptions

Massive monetary easing

US M3 growth


At first sight, the data seems to bear out that there was massive money creation and we have triumphant articles from monetarists like Evans-Pritchard arguing for the superiority of monetarism over competing frameworks:

Monetarists are suddenly the new superstars, and deservedly so. The score of the last 20 months is nul points for the hegemonic New Keynesian group-think: douze points for the forgotten quantity theory of money. The tiny fraternity of monetarists who track esoteric M1, M3, M4 "aggregates" warned in late 2020 that the money supply across the West was becoming unhinged, and that this in turn was incubating double-digit inflation - or something close - with the typical lag of one to two years.

That case seems unarguable, isn't inflation always and everywhere a monetary phenomenon? However:

  • Have we forgotten how monetarism (that is, targeting monetary aggregates as a policy goal) failed abjectly in the 1980s and was quickly abandoned, basically because these aggregates were all over the place.
  • Have we forgotten how there has been massive monetary easing in the form of QE and zero (or even negative) interest rates for much of the decade following the financial crisis (and in Japan well before that), without this having caused as much as a blip in inflation?

Well, monetarists could argue that we simply look at the graph of US M3 growth above again and notice that the growth in the aftermath of the pandemic was dramatically larger than that in the aftermath of the financial crisis.

It's here where things get interesting because the QE packages weren't actually all that different:

Fed Balance Sheet

American Action Forum

In the aftermath of the financial crisis, the Fed balance sheet ballooned from under $1T to over $4T a more than a four-fold increase, while in reaction to the pandemic the balance sheet increased from $4T to $9T, a little more than double.

One should cause no blip in inflation whatsoever whilst the other produces nearly double-digit inflation? Really? There is more to it than that.

Fiscal stimulus

Which brings us to Larry Summers, as he argued that the size of the fiscal stimulus is what set off inflation. There is much to be said for this:

  • The size of the pandemic fiscal stimulus was indeed dramatically larger than the one following the financial crisis.
  • Public spending is actually one of three ways to get money in circulation, QE alone isn't enough to produce a surge in the money supply.

QE is basically the Fed buying financial assets like Treasuries or mortgage-backed securities), mostly from banks, for which it credits bank balances held at the Fed which are the largest part of bank reserves or M0:

US M0 growth


The graph above shows that M0 growth was twice as high in the aftermath of the financial crisis compared to the pandemic. Increased bank reserves enable banks to increase credit creation, and credit creation is money creation as households and/or business bank accounts are credited with money that previously didn't exist.

However, if banks do not respond by increasing credit to the non-bank public, no additional money will be created. Rather than increase lending, banks sat on excess huge reserves (which actually earned a small interest rate):

Bank reserves


Credit creation by financial institutions was actually fairly muted in the 2010s, compared to the previous decade:

US credit creation


This isn't so surprising because the process of money creation usually starts with credit demand, banks respond based on their criteria and then look for the reserves, it's a demand-led process, not usually constrained by a lack of supply of reserves.

And for much of the 2010s, fiscal policy was actually restrictionary and that only really changed with the Trump tax cuts. In combination with the deleveraging of households (paying off debt rather than taking on new debt) as a result of their large debt overhang, this produced a tepid demand for credit despite the record-low interest rates and despite banks basically drowning in reserves.

But there are two other ways in which money can be created:

  • Public expenditures directly crediting accounts
  • Unsterilized central bank intervention to keep the currency from rising

The Fed rarely intervenes in the currency markets but what was different in the aftermath of the pandemic was the huge direct public payments to businesses and households, directly increasing money in circulation.

We've always argued that QE was an extraordinarily inefficient way to stimulate the economy (with Ben Bernanke even arguing that it works in practise, not in theory) as it blows up asset prices and might create something of a wealth effect or fractionally lower long-term interest rates, but these don't really do all that much for the economy.

Fiscal policy however is a very powerful tool in a zero or low interest rate environment, especially when money is given to households with a large propensity to spend, as was the case during the pandemic.

And it is fiscal policy that Larry Summers blamed for the outbreak of inflation, basically, the size of the stimulus was too big, in his view.

But is it really the fiscal and monetary policy extravaganza that is causing the upsurge in inflation? What has to be stressed is that these were one-off policy reactions, however large they were, they have gone in reverse already.

Here is Simon Ward from Janus Henderson (The Telegraph):

Simon Ward from Janus Henderson says a key measure of the US money supply - six-month real M1 - has fallen to near zero from a peak of almost 25pc during the pandemic, when the Fed flooded the system with emergency liquidity. The broader M2+ measure has turned negative. These signals imply that the underlying props of the Wall Street boom are crumbling. The effect is compounded by a powerful downswing in the inventory cycle. Mr Ward said the closest parallel is the US recession of 1970, which led to a 35pc fall in equities. Slowing money growth also implies that inflation will come down of its own accord gradually without the need for a violent squeeze by central banks.

And fiscal policy already is a drag on the economy (Brookings Institute):

Fiscal policy reduced U.S. GDP growth by 3 percentage points at an annual rate in the first quarter of 2022, the Hutchins Center Fiscal Impact Measure (FIM) shows. The FIM translates changes in taxes and spending at federal, state, and local levels into changes in aggregate demand, illustrating the effect of fiscal policy on real GDP growth. GDP fell at an annual rate of 1.4% in the first quarter, according to the government's latest estimate.

Fiscal impact

Hutchins Center

With monetary and fiscal policy already in reverse, there is something else keeping inflation up, and it's not difficult to see what.

Supply chain problems

The pandemic caused myriad supply chain problems and recently the war in Ukraine and the Chinese lockdowns have worsened and prolonged these.

One should also not lose sight of the fact that the extremely tight labor market in the US is not only caused by booming demand, but labor supply is still well below pre-pandemic levels:

United States Labor Force Participation Rate

Trading Economics

Stagflation? Recession?

Summers argues that there's never been a moment when we had inflation over 4% and unemployment below 4% when we didn't have a recession within the next two years.

Indeed, the unprecedented scarcity of labor indicates:

  • It will take a considerable amount of economic slowdown to cool off the excess demand for labor.
  • The longer the scarcity of labor prolongs in time, the higher the chance it will drive a wage-price spiral like in the 1970s.

There are counterarguments. A wage-price spiral is less likely as labor's bargaining power is much less compared to the 1970s. Also, as we have discussed above, the fiscal and monetary stimulus have already gone into reverse and fiscal policy in the US is actually contractionary already.

However, there is a complication, a big one. Inflation isn't likely to subside anytime soon because supply disruptions have worsened, the result of the war in Ukraine and the Chinese lockdowns.

McKinsey cataloged 12 major disruptions for the world economy to cope with as a result of the war in Ukraine, and we add that a prolonged stalemate is a likely outcome as:

  • Russia isn't winning
  • Putin is unlikely to give up trying, for fear of losing face to a domestic audience

There is a chance that Russia will be driven back, given the difficulty to replace losses of men and materials and low morale (and we're seeing this happening on a small scale around Ukraine's second-biggest city Kharkiv), but it's one thing to stave off a Russian offensive, quite another to drive them all the way back to Russia.

So unless one side suddenly collapses (most likely Russia given the low morale and difficulty to replace men and materials), this war looks set to be a prolonged affair as a settled negotiation is also difficult to imagine.

Russia has to take some positive win out of a settlement, in terms of additional Ukrainian territory but Ukraine, for all their efforts and damage to people and country, isn't likely to agree to any of that.

In fact, quite the contrary as it's difficult to imagine how Ukraine will settle for anything less than for Russia to give up on Donbas and Crimea and guarantee the integrity of Ukraine's border.

Some supply chain relief will come from the ease of the Chinese lockdowns, particularly that of Shanghai, but the pandemic can flare up again at any moment and it doesn't take much for authorities to slam on the brakes again.

In short, supply chain issues aren't going to go away anytime soon, and with these inflationary pressures. Central banks are ill-equipped to deal with supply chain issues, which are a supply-side issue whilst their policy instruments work on the demand side.

Which makes the risk of monetary policy overshooting and the US economy falling into a recession a pretty substantial one, especially as central bankers are eager to re-establish their anti-inflationary credentials.

There isn't actually all that much that policymakers in Washington can do about the present inflationary surge either, apart from stuff like decongesting ports and other transport hubs, increasing labor supply (child support, immigration), or reducing tariffs, to name a few policy options.

Tariff reduction especially could produce an immediate and sizable effect, the Peterson Institute of International Economics calculated:

a 2 percentage point reduction in tariff-equivalent barriers would deliver a one-time decrease in CPI inflation of 1.3 percentage points (0.2 percentage point plus 1.1 percentage points).


  • On its own, QE policy or zero interest rates are unlikely to produce runaway inflation if not accompanied by a credit boom, which they weren't in the aftermath of the financial crisis and neither in the aftermath of the pandemic. So the Fed didn't produce the present inflationary wave.
  • At very low interest rates, fiscal policy becomes very powerful and that has produced a boom in demand post-pandemic in the US and it leads to a direct increase in the money supply if put directly into people's pockets.
  • But it's hard to see one-off monetary and fiscal stimulus producing a sustained rise in inflation, especially as monetary and fiscal policy have already gone into reverse and fiscal policy is already contractionary.
  • What is producing the present bout of sustained high inflation is mostly due to the myriad bottlenecks in commodities, components, logistics, and labor supply collectively known as 'supply chain issues.'
  • Given the pernicious effect of the Ukraine war and the Chinese lockdowns, supply chain issues have worsened considerably and are not likely to disappear anytime soon.
  • While the Fed can slow the economy, it's ill-equipped to deal with these supply chain issues and the danger is they will produce an overkill of monetary tightening in order to re-establish their anti-inflationary credentials, producing the worst of both worlds in which we have inflation combined with low growth or even a recession.

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