The Bureau of Labor Statistics just released its latest report on the Consumer Price Index. As expected, the data looks bad. The year-over-year increase in November was 6.8%. Inflation is now at its highest level since 1982 -- that is, in almost four decades.

Cue the blame game as media pundits seek to explain away the inflation. Supply-chain bottlenecks are the culprit, they say, together with a tight labor market, pent-up demand from the pandemic, price gouging, and the latest round of covid variants.

On the surface, these all seem plausible explanations for the recent price hikes. Inflation, after all, is a complex phenomenon; there are many variables that factor into the general price level.

For some strange reason, however, few politicians or media pundits care to point out the 800-pound gorilla in the room.

The culprit behind our current inflationary crisis is manifest. The main culprit is the Federal Reserve and its extreme monetary response to the COVID pandemic.

Since the pandemic, the US money supply has increased by a whopping 37%. M2 (the most common measure of the money supply) was $15.5 trillion at the beginning of March 2020. By November 2021, a mere twenty months later, M2 exceeded $21 trillion.

This is the most rapid acceleration in the money supply since World War II.

The graph below (Figure 1) shows M2 over the last 40 years. While the money supply has drifted consistently upward over the last half century, the line goes almost completely vertical from 2020 to the present day.

[Figure 1]

Figure 2 (below) shows Real M2, adjusted for inflation (with 1982-84 dollars serving as the base), from 1959 to the present day. Here too, we see the line take a vertical turn in 2020.

[Figure 2]

If those graphs do not alarm you, they should.

How did the money supply expand so rapidly?

The federal funds rate returned to zero after the onset of the pandemic, of course. But more importantly, Fed Chairman Jerome Powell went absolutely wild with quantitative easing (QE).

As seen in Figure 3 (below), the Fed’s balance sheet soared from $4.2 trillion at the beginning of March 2020, to $8.66 trillion in December 2021. In other words, the Fed’s total assets (Treasurys and mortgage-backed securities) have more than doubled since the onset of the pandemic. The Fed purchased these assets with newly created (out of thin air) dollars. All this occurred, again, in less than two years’ time.

[Figure 3]

The Fed’s balance sheet has increased exponentially before, as the same graph (Figure 3) exhibits. Former Fed Chairman Ben Bernanke famously embarked on a massive program of quantitative easing in the aftermath of the 2008 financial crisis. The Fed’s balance sheet went from $900 billion in August 2008 to $4.1 trillion by the time Bernanke left the Fed in January 2014.

But during Bernanke’s time as Fed Chair, the vast majority of QE never entered the real economy. Most of it was in the form of reserve balances held by depository institutions at the Federal Reserve. Before the 2008 financial crisis, excess reserve balances were negligible -- on average, some $20 billion at any one time. By the end of 2009 there were over $1 trillion (one thousand billion) in excess reserve balances, and when Bernanke left the Fed in January 2014 the number was $2.5 trillion (see Figure 4).

[Figure 4]

Though the Fed’s balance sheet increased by $3.2 trillion between 2008 and 2014, the excess reserve balances of depository institutions increased by some $2.5 trillion. That money never entered the real economy and did not even count as part of M2.

Therefore, despite Bernanke’s drastic rounds of QE between 2008 and 2014, M2 never increased at anywhere near the pace that we have witnessed in the last two years. M2 was $7.8 trillion at the beginning of October 2008. By the end of Bernanke’s term in January 2014, M2 was $11 trillion. In over five years’ time, the money supply increased 42%.

Powell’s Fed, since March 2020, has superintended a 37% increase in M2 -- in only a third of the time that it took Bernanke’s Fed to witness similar growth. Bernanke never struggled with significant inflation; Powell is staring down the worst inflation in more than a generation.

What accounts for the discrepancy?

First, QE under Powell has been more intense and more concentrated than Bernanke’s QE. The Fed under Bernanke grew its balance sheet by $3.2 trillion in a little less than six years; Powell’s Fed has grown its balance sheet by $4.5 trillion in less than two years.

Moreover, unlike the QE under Bernanke, a significant amount of Powell’s quantitative easing has entered the real economy. Reserve balances are up since the beginning of the pandemic struck (Figure 4), but only by $2.5 trillion. The Fed’s balance sheet, meanwhile, grew by more than $4.5 trillion.

Translation: M2 has risen a lot faster under Powell than it ever did under Bernanke (see Figure 1).

Powell finds himself in an extraordinarily difficult predicament. Though the Dow is at an all-time high and the official rate of unemployment rate remains low, economic growth has been sluggish. The economy grew at an annualized pace of only 2% in the third quarter, far below expectations. If the Fed raises interest rates -- even if only a little -- it would undoubtedly risk bringing the economy into recession. However, to bring inflation under control, the Fed must raise rates in 2022, and the rate hike must be far more than a quarter of a percent here or there. During the last inflation crisis, 40 years ago, Fed Chairman Paul Volcker sent the federal funds rate above 20% (Figure 5). The rate today is less than a quarter of a percent. Clearly this is not sustainable. Yet even a mild hike in interest rates has the real potential to wreak havoc in asset values, the mortgage market, the bond market, and the government’s ability to finance its enormously unsustainable debt. But if Powell doesn’t act -- if QE doesn’t rapidly end and interest rates do not move significantly upward -- the Fed risks inflation heading into double digits in 2022, just as Americans saw in the 1970s.

[Figure 5]

The chickens, in other words, will soon come home to roost -- whether in the form of a new economic recession or via double-digit inflation. Either outcome is a disaster for the Biden administration, which will assuredly (and not entirely unfairly) receive the bulk of the blame from the voting public. But Trump, if he had won a second term, would have also faced a major inflation problem. Though a healthier supply chain and labor market might have allayed some of the inflationary pressures under a second Trump term, the chief cause of inflation – growth in M2 – would have been unchanged.

Make no mistake, the Fed is the true culprit behind our latest inflationary crisis.

All graphs via Federal Reserve Bank of St. Louis

Jonathan Barth is an Assistant Professor of History at Arizona State University. His History of Money course, as well as other lecture content, is available on YouTube.

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