Monetary Policy in Response to the Pandemic and the Prospects for Inflation over the Next Few Years

In 2020, the Federal Reserve expanded the money supply substantially, with M2 increasing by more than 22 percent from December 2019 to December 2020. This was accompanied by an even larger increase in the monetary base. As spending declined dramatically in the weeks following the implementation of shutdown orders connected to the pandemic, the monetary expansion was intended to offset the contractionary effects of that spending decline. Although CPI inflation rates remain low, below the Federal Reserve’s 2 percent target, there is good reason to expect that if the Fed does not act to restrain the rate of monetary expansion in the next year or two, we will see a substantial increase in inflation.

With interest rates as low as they are and continued reductions in certain categories of consumption spending, the effect of the increase in the money supply has largely been to offset the increase in money demand induced by the pandemic and response to it. But eventually, people will start spending again and reduce their rate of saving. Although some of the increased spending may stimulate increased supply of real goods and services, potential output is limited by the economy’s productive capacity. Thus, although inflation may remain subdued for a few more months, as the economy approaches capacity, more money likely means that spending will continue to increase. To the extent that the increase in output cannot keep up with the increase in spending, we will see inflation.

Hetzel argues that if the Federal Reserve sticks to its announced commitment to overshoot its 2 percent inflation target and to keep interest rates near zero, then inflation may well rise to the point where it becomes a problem. He equates recent monetary policy to the expansionary monetary policy of the 1960s. During that time, the Fed was able to exploit widespread expectations of price stability to use expansionary monetary policy to stimulate output and employment. But as that expansionary monetary policy continued, it eventually led to runaway inflation.

Because inflation has been low for so long, market participants are now expecting prices to remain stable. This makes it easier for the Fed to pursue expansionary monetary policy with no short run increase in inflation. But, just as in the 1960s, rapid money growth will eventually lead to inflation, even though the lag may be long. By committing to allow inflation to overshoot the two percent target, the Fed has effectively taken away the option of preemptively restraining money supply growth to keep inflation from rising to well above 2 percent before changing course.

Given its commitment to keep interest rates low until we actually see inflation, the Fed may wait too long to reverse its policy. The likely consequence is inflation overshooting what even the Fed might consider reasonable and that for as much as a year or two, given what we know about the length of lags in the past.

Thus, we should be prepared for an increase in inflation in the next few years.