Powellomics, not Bidenomics, Caused the 2021-22 Surge in Inflation

Living in a “swing” state, I am bombarded with political television ads. The GOP ads blame the 2021-2022 surge in inflation on Bidenomics and, by association, Harrisomics. A number of the elements of Bidenomics increased the federal budget deficit. But I will argue that federal budgetary deficits do not cause higher inflation. Rather, the actions of the Federal Reserve and the depository institution system cause higher sustained inflation rates by their combined ability to create credit figuratively out of thin air. The Federal Reserve and the depository institution system are, in effect, legal counterfeiters, i.e., they have the unique ability to create credit, figuratively, out of thin air. (Thin-air credit here will be defined as the sum of the Federal Reserve liability items, reserve deposits and vault cash of the depository institution system, currency held by the non-depository institution system, and the sum of depository institution system items, debt securities and loans. (An equivalent definition of thin-air credit is the monetary base, created by the Federal Reserve plus credit created by the depository institution system.) When credit is created out of thin air, the recipients of this credit are able to increase their spending without necessitating any other entity to reduce its spending. With some exceptions, when an entity other than the Fed/depository institution system lends to another, the lender reduces its current spending, transferring spending power to the borrower. This is called saving on the part of the lender.

Let us look at some data relating net federal borrowing as a percent of nominal GDP versus thin-air credit growth to goods/services price inflation. The inflation measure I will use in this analysis is the chain-price index for Gross Domestic Purchases. This inflation measure includes the prices of personal consumption expenditures, business expenditures, residential real estate services expenditures and government expenditures on goods/services. It excludes the prices of US goods/services exports. I have tested lead-lag relationships between net federal borrowing and inflation and thin-air credit growth and inflation. For both variables, the highest correlation coefficients occur when both net federal borrowing and thin-air credit growth lead inflation by two years. So, this year’s inflation rate is most highly correlated with net federal borrowing and/or thin-air credit growth two years prior.

If federal government net borrowing influences inflation, we would expect a negative correlation between the two series. And that is what we observe in Chart 1. The correlation coefficient between the two series is negative 0.14. Although the correlation coefficient has the correct sign, the absolute value of its magnitude, 0.14, is low, suggesting that there is not much association between the two series.

If thin-air credit growth influences inflation, we would expect a positive correlation between the two series. And that is what we observe in Chart 2. The correlation coefficient between the two series is positive 0.61. The magnitude of the absolute value of the correlation coefficient is 0.61, which suggests a relatively high association between the two series.

A multivariate linear regression allows us to measure the effect on inflation given net federal borrowing and given thin-air credit growth. I ran such a regression with both net federal borrowing and thin-air credit growth lagged two years. Both coefficients on the independent variables had the “correct” signs. The coefficient on federal net borrowing as a percent of nominal GDP was -0.06; the coefficient on thin-air credit was +0.44. So, the effect of thin-air credit on inflation was much higher than that of net federal borrowing. In addition, the t-value on the thin-air credit coefficient is +6.07, which implies there is high probability that the thin-air credit growth coefficient is associated with inflation. In contrast, the t-value on the federal net borrowing coefficient is -0.72, which implies that there is a very low probability that federal net borrowing is associated with inflation.

If inflation is the result of “too much money chasing too few goods”, then that is exactly what we saw in 2020, as shown in Chart 3. Because of Covid, real GDP contracted by 2.2%, i.e., too few goods and services. At the same time, thin-air credit increased 15.7%, i.e., too much “money”. The big surprise would have been if inflation subsequently had not spiked!

There’s an old University of Chicago School of Economics thought experiment. What would happen if the government dropped money from a helicopter? Well, in 2020 and 2021, with the help of the Federal Reserve and the depository institution system, the federal government figuratively did drop money from a helicopter. In 2020-21, in response to Covid, the federal government mightily increased its transfer of funds to households and businesses. In 2020, unemployment insurance accounted for a lot of these transfers. In 2021, the American Rescue Plan legislation transferred funds to households above and beyond unemployment insurance. This resulted in sharp increases in net borrowing by the federal government. As shown in Chart 4, increases in thin-air credit nearly matched the increases in net federal borrowing. The increase in net federal government borrowing did not cause the increase in thin-air credit. The Federal Reserve did not have to allow the massive increase in thin-air credit. It chose to because it tends to believe that weakness in aggregate domestic spending arises because of some demand deficiency rather than a negative supply shock. The Fed followed the same playbook after the negative supply shock of the oil embargo in 1973. Chart 5 answers the question of what happens after the government drops “money” from a helicopter. With a lag, the private domestic sector increases its nominal expenditures and higher inflation occurs.

If the Fed and the depository institution system had not created the massive amounts of thin-air credit, which financed nearly all of federal government net borrowing in 2020-21, the public, including foreign entities would have had to finance the government borrowing. This would have resulted in higher interest rates in order to induce more private-sector saving. Some recipients of federal government largesse would have increased their spending whilst others reduced their spending, i.e., increased their saving. Nominal GDP and inflation would not have increased to the degree that they did with the thin-air credit financing of the net federal government borrowing.

There might be legitimate reasons to criticize Bidenomics. But higher inflation is not one of them. Powellomics was responsible for the surge in inflation in 2021 and 2022. Federal Reserve Chairman Powell and his coterie are responsible for setting the inflation fires of 2021 and 2022. Starting in 2022, the Fed began taking actions to extinguish the inflationary fires that it had started earlier. The Federal Reserve is not malicious. Rather, it is incompetent. In the face of a negative supply shock in 1973 caused by the oil embargo, the Fed aided and abetted the inflation that followed. The Fed provided the gas to inflate the housing bubble in the mid 2000s. Asset prices are not captured in goods/services price indices. But asset prices, too, can rise because of excessive growth in thin-air credit. And, as I have argued here, the Fed set the inflationary fires that flared following the negative supply shock of Covid. Not only does the Fed’s incompetence have economic consequences, it has political consequences, such as blaming Bidenomics for the 2021-22 surge in inflation. The Fed operates in the shadows of general public understanding with no effective accountability. The Fed was established by law in 1913 and is supposed to be accountable to Congress. But Congress uses hearings of Fed officials as soapboxes from which to air political criticisms for their constituents back home rather than holding the Fed accountable for its policy errors.

With seemingly random economic shocks, changing economic relationships over time and changing lag structures, it would be a Herculean task for the Fed to anticipate all of these uncertainties and act accordingly. But it would be possible for the Fed to not amplify the effects of these difficult to anticipate shocks. If the Fed were to act so as to produce a steady rate of growth in thin-air credit, business cycles and inflation flare-ups still would occur. But the amplitudes of these would be reduced. What might the rate of growth in thin-air credit be? From 1955 through 2023, the median year-over-year growth of real GDP has been 3.0%. Going forward, growth in the labor supply is expected to slow, which, all else the same, would lower growth in real potential GDP. But with new technologies, including AI, coming on stream, labor productivity could be expected to increase, which would be a plus for real GDP growth. So, why not have the Fed produce a growth rate in thin-air credit of five percent, three percent real GNP growth and two percent for inflation?