Blog Post - Views on the Economy and the World

Fighting the Last Inflation War

| Feb. 28, 2022

When Fed Chairman William McChesney Martin delivered his famous line about central banks, his key point was that it is their job to take away the punch bowl just when the party really gets going, rather than waiting until revelers have turned drunken and raucous. In the aftermath of the 1970s inflation, it became an item of faith that monetary authorities shouldn’t wait until elevated inflation shows its face, before reining in an overheating economy.  They are currently developing a renewed appreciation for the wisdom of this old metaphor.

During the decade that began with the Global Financial Crisis (GFC) in 2008, some central bankers arguably followed this time-honored practice into episodes of unnecessarily tight monetary policy.  In retrospect, they at times over-estimated the dangers of inflation.  [More on this below.]  They were “fighting the last war.”

Last year, central bankers once again “fought the last war,” this time by under-estimating the danger of inflation, as economic recovery began to run into capacity constraints.  The US unemployment rate dipped below 4.0 percent by December.  In the end, 2021 inflation exceeded 7 percent, the highest in 40 years. A good old-fashioned Phillips curve could have predicted this.  The prominent inflation warnings of Larry Summers and Olivier Blanchard in February of 2021 were proven right. The Fed’s view that any inflation would be transitory was shown to be overly optimistic.  It is now having to play catch-up.

Central banks over-estimated inflation in 2008-18

The experience of 2008-18 suggested that expansionary monetary policy could promote growth, and ultimately drive US unemployment below 4 %, with few adverse effects in terms of inflation and interest rates.  This realization did not require a fundamental re-thinking of macroeconomic theory, contrary to what one often reads.  The conclusion, rather, followed naturally from the proposition that the economy at that time was operating on the low, flat part of the “LM curve,” and the low, flat part of the Phillips curve.

Consider four cases during 2008-18 when the danger that monetary ease would lead to inflation was over-estimated.

First, the European Central Bank (ECB) actually raised its policy interest rate in July 2008. It soon corrected its mistake, easing sharply in November-April, after the full-fledged GFC had become evident.  But then it raised rates again in April-July 2011. The first hike was probably an over-reaction to rising oil prices, and the second was a premature expression of victory in combating the GFC. (Mario Draghi came to the rescue in 2011.)

Second, Sweden’s Riksbank did the same: it raised interest rates in 2008, up through September, and, more egregiously, raised rates by 175 basis points in 2010-11.

Third, even more clearly mistaken in 2010 was a famous letter to Fed Chairman Ben Bernanke from a group of 24 economists, academics, and hedge fund managers, opposing the Quantitative Easing then underway and warning that it would not promote employment, but rather would risk “currency debasement and inflation.”  As should have been clear at a time when unemployment still exceeded 9 %, there was in fact no reason to fear that stimulus would lead to excessive inflation.  The consensus among economists is that the aggressive easing of monetary policy in the aftermath of the 2007-09 recession was fully justified.  (The same is true of Obama’s 2009-10 fiscal stimulus, which, if anything, should have been bigger and more sustained.)

Fourth, and more of a surprise to most economists, was the period 2016-18. US GDP rose above its estimated potential and unemployment fell below 4 percent. In the past, this had usually signaled overheating of the economy.  So, it is understandable that the Fed began to raise interest rates in 2016, and continued to do so through the end of 2018, in an attempt to move back toward normalcy.  Yet, in the end, very little of the feared inflation materialized, suggesting in retrospect that the economy could have been allowed to “run hot” for longer.  Apparently, the Phillips curve, if not dead, was supine.

Central bankers under-estimated inflation in 2021-22

Now inflation is back.  It turns out that when demand increases faster than supply, inflation results after all, just as the textbooks say.  The sloping Philips Curve is alive and back on its feet again.  But the Fed, not wishing to repeat the mistake of 2018, under-estimated the danger of inflation in 2021.

Incidentally, contrary to widespread reporting, US inflation did not “rise 7%” last year.  Rather, the price level rose 7%.  Or inflation reached a 7% level.  But to say “inflation rose 7%” would imply that inflation rose from its 2020 rate of about 1 percent to 1.07%. (Or perhaps from 1 % to 8 %, though that should be described as inflation rising “7 percentage points,” if one really wanted to be clear.)  The point may sound pedantic. But there are contexts in which the habit of mixing up the level of inflation and the change in inflation could leave the reader at sea, unable to tell which is meant.

The pandemic in March 2020 caused both a fall in Aggregate Supply and a fall in Aggregate Demand.  That explains the sharp recession in the second quarter.  The big monetary and fiscal stimulus in the US explains the subsequent rapid recovery.

What explains the absence of inflation in 2020?  (Inflation actually fell in the 2nd quarter, largely due to a brief plunge in oil prices.)  The obvious textbook answer is that the negative shock to demand must have been initially larger than the negative shock to supply before monetary and fiscal stimulus kicked in.

A second possible answer is less orthodox.  Consider the example of a run-on toilet paper, resulting from an emergency or disaster like the pandemic. Although economists think the best response is to raise prices before inventories disappear entirely, nobody else thinks that. Consumers, retailers, and toilet paper manufacturers – who are the ones that matter — would call it “price-gouging” and express moral disapproval.  So, prices remain unchanged. Later, when the sense of emergency eases, manufacturers and retailers can raise their prices without the same moral opprobrium, especially when they can point to rising costs (including supply-chain disruptions).  Despite well-known shortages early in 2020, the price of toilet paper did not rise until 2021.

If there is any truth in this hypothesis, the 7 % inflation rate of the last year may have included some “catch-up” by firms.  That could in turn imply some moderation in inflation during the coming year — unless rising prices for oil, natural gas, wheat, and other commodities dominate the price indices.

Time for the disappearing punch bowl

In any case, it is time to take the punch bowl away. Inflation is not the only evidence of overheating. US GDP growth has been rapid and the labor market is tight.

The Fed has almost completed the accelerated ending of QE.  Taking away the punch bowl means more than this, however. It means raising interest rates, of course, as the Fed is expected to start doing in March. As Jason Furman and others have pointed out, an increase in expected inflation calls for a matching increase in the nominal interest rate, even before the Fed begins to raise the real interest rate and to tighten financial conditions generally.

It also means the central bank normalizing by gradually getting rid of unconventional assets that it has accumulated on its balance sheet, particularly (in the case of the US) mortgage-backed securities. (The Fed even bought corporate bonds in March 2020, selling them in 2021.)  The Bank of England has already begun to sell off some of the bonds it holds, including corporate debt.

It is still a good principle that leaving aside exceptional circumstances like the GFC and covid recessions, central banks should seek to minimize holdings of assets that influence the sectoral allocation of credit. The reasoning is that, when society wants to boost a particular sector, it should do so directly through the government, which has democratic accountability.

Another advisable step would be a return to more aggressive financial regulation.   In some countries, this starts by tightening reserve requirements on banks.

Meanwhile, the European Central Bank may still be fighting the last war.  Unlike the Fed and the Bank of England, it has not yet begun to taper QE, let alone to raise its interest rate, which is still negative 50 basis points.  It may be seeking to avoid mistakes of 2008-2011, when it failed to sustain stimulus in the wake of the GFC.  (Admittedly, Europe has not seen quite as much demand expansion, growth, and inflation as the US.)

The syndrome of “fighting the last war” stems from human nature.  The events of recent years, such as 2008-2018, are more salient in perceptions than is the longer-term history.  Paying extra attention to the developments of the recent past can be justified by pointing to fast-paced fundamental changes in technology and society.  But the long-term history contains wisdom derived from a wider variety of circumstances.


For more information on this publication: Belfer Communications Office
For Academic Citation: Frankel, Jeffrey.Fighting the Last Inflation War.” February 28, 2022,