Yellen Blaming Consumers for Inflation Is Government’s Latest Attempt to Deflect

A few weeks ago, US Secretary of the Treasury Janet Yellen appeared on the Late Show With Stephen Colbert to discuss a range of issues both political and personal.

The most widely reported moment in the interview came when Yellen talked about practicing her signature (don’t ask me why this is newsworthy, I have no idea). However, a significantly more important moment has not gotten the attention it deserves.

When asked by Colbert to explain the reasons behind the worst inflation the US has experienced in 40 years, the former Federal Reserve chair blamed it primarily on rising consumer spending—Americans “splurging” on goods—at the start of 2021 once the Covid-19 lockdowns were lifted. This, compounded with supply chain issues and the war in Ukraine can sufficiently explain inflation, Yellen claims.

But can it really? Let’s take a closer look.

The Real Reason For Inflation

Yellen’s explanation is not wholly inaccurate; it is true that consumer spending rose above pre-pandemic levels at the start of 2021 and continued to rise at a notably fast rate for many subsequent months—which puts upward pressure on prices. At the same time, this is in no way a complete explanation of the inflation we are seeing now.

Yellen’s explanation does not capture inflation’s primary culprit, both in this case and historically: expansionary monetary policy. From February 2020 to February 2021, the money supply as measured by M2 (the broadest measure of the money supply) increased by 27 percent. It increased by another 11 percent from February 2021 to February 2022. This means that, over the first two years of the Covid pandemic, the money supply increased by 41 percent. To put that in perspective, from 2010 to 2019, this measure of the money supply rose by 5.8 percent annually.

In a 60 Minutes interview, Chairman of the Federal Reserve Jerome Powell replied “Yes, we did,” when asked if he simply “flooded the system with money” during the pandemic.

The consequence of such a drastic rise in the money supply is clear: a drastic rise in inflation.

The Evidence

The reason this is the case should be intuitive (increasing the amount of money in the economy boosts the relative demand for goods and services, which puts upward pressure on prices) but it can also be demonstrated theoretically and examined empirically using what is known as the quantity theory of money. This theory has roots that can be traced back hundreds of years but remains as relevant as ever today, with most economists accepting its core insight as accurate.

The quantity theory of money is based on the “equation of exchange”: MV=PY, where M is the quantity of money, V is the velocity of money (the average frequency at which a unit of money is used to purchase goods during a given period), P is the average price level, and Y is real GDP.

If the value of one side of the equation rises or falls, there must be a similar shift on the other side. Based on this, we can understand that there is a positive relationship between money supply and price level, all other variables held constant.

This is particularly true if we accept that a nominal variable such as money cannot influence a real variable like GDP (Y); it would mean that the entire impact of a rising money supply falls on price level, rather than price level and real GDP).

In the context of the economic developments since February 2020, it becomes clear why we now see inflation. M rose dramatically for a two year period; however, it initially did not cause a hike in the left side of the equation (MV) because of a decline in V at the start of the pandemic. But once V inevitably adjusted back to baseline as restrictions were lifted, MV rose and an increase in the left side of the equation (PY) was necessary in order for the identity to hold. The spike in price level (inflation) following a rapid rise in the money supply and a return of other variables to their baseline could have easily been predicted using this theory and equation.

Put simply, as the supply of any good, including money, increases, the value of that good will fall relative to the value of other goods. In other words, creating more money means money will have a lower purchasing power than if the money was not created.

That this is the proper explanation for inflation, and that the quantity theory of money remains valid, is borne out empirically. The graph below—created by two economists at Johns Hopkins University and presented in the Wall Street Journal—shows expected inflation based on the quantity theory of money equation (MV=PY) plotted next to actual inflation as measured by the GDP deflator over the past 60 years. The extent to which the two track is striking. The only deviation from the relationship took place at the start of the Covid-19 pandemic; but, by the middle of 2021, the equation of exchange was once again a near perfect predictor of…