In two previous columns, I have argued that the leading explanations of the post-pandemic inflation are wrong.
Supply chain disruptions do not cause inflation. Supply chain disruptions cause the prices of a narrow set of goods and services to increase. Inflation is when the prices of a broad range of goods and services increase, then increase some more, then increase some more, then increase some more, and so on.
Rising wages do not cause inflation. Wages increase as worker productivity increases: the more productive workers are, the more employers are willing and able to pay them. Rising productivity pays for rising wages.
Inflation has a single cause: excessive money supply growth. The post-pandemic inflation is no exception.
From 2000 thru 2019, the U.S. money supply increased at an average annual rate of 6.2%. In 2020, it increased by 25.7%, and in 2021, by another 11.4%. From February 2020 to February 2022, the U.S. money supply increased by 40.4%. That’s what caused the 12-month rate of inflation to rise from 1.4% in January 2021 to 8.9% in June 2022.
So, what caused the surge in money supply growth in 2020 and 2021?
The actions the Federal Reserve took to prevent a global financial catastrophe at the onset of the coronavirus pandemic, coupled with the actions it took to keep banks abundantly stocked with reserves through the pandemic, caused the surge in money supply growth in 2020 and 2021.
On February 23, 2020, the Italian government imposed a lock down on eleven towns in the hope of containing a massive outbreak of coronavirus. In financial markets, the news prompted panic and an immediate “rush to safety.” Investors rushed to sell higher yielding assets and rushed to buy “safe haven” assets, primarily U.S. Treasury bonds and bonds issued by the governments of Japan, Germany and the U.K.
In the last week of February 2020, the value of U.S. blue chip stocks fell by 12%, while the yield on ten-year U.S. Treasury notes fell to a record low 1.13%.
As the outbreak spread and intensified, panic in financial markets did, too. On March 9, blue chips dropped by 7.8% before New York Stock Exchange officials halted trading. The yield on the ten-year Treasury note hit 0.54%.
Then came the meltdown. As markets opened on March 16, financial institutions and investors began unloading assets, including safe haven assets, for cash. Sell orders inundated the U.S. Treasury bond market. Stock prices plunged, bond yields spiked, and short-term credit channels froze. Liquidity in the global financial system was rapidly evaporating.
The Federal Reserve had been adding liquidity to financial institutions since February 23. On March 16, it opened the floodgates. It purchased hundreds of billions of dollars in Treasuries that the institutions were frantic to sell. It announced it would continue to purchase assets in large amounts until credit markets functioned smoothly again. It also set up funding facilities to provide short-term credit until frozen short-term credit channels thawed.
The meltdown ceased. By July, credit markets functioned smoothly. With no end to the pandemic in sight, the Fed opted to reduce its asset purchases rather than end them, to further fortify banks.
In preventing a global financial catastrophe and in keeping banks abundantly stocked with reserves through the pandemic, the Fed increased its holdings of Treasury securities and other assets from $4,170 billion in February 2020 to $7,128 billion in June 2020, and to $8,934 billion in February 2022. Banks turn reserves into loans, and loans increase the money supply – in this case by 40.4% from February 2020 thru February 2022. And that, as we’ve discussed, caused the post-pandemic inflation.
Reg Murphy Center