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The Fundamentals Point to Inflation That's Much More than "Transitory"

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Paul Krugman is at it again, this time with a series of a series of tweets that repeatedly miss the reality of price inflation and its causes. Let’s take a closer look:

We truly live in an era of statistical superlatives. Among multiyear records of debt, market highs, and government spending, we now have inflation as well, which reached a thirty-year high in November of 2021, hitting an annual rate of 6.2 percent.1

The transitory line of thinking about inflation has been echoed heavily by fiscal and monetary policymakers. Of course, it has also been pushed by none other than Paul Krugman, who in a series of tweets admits to failing to predict the current surge in prices but still doubles down on his flawed logic, suggesting that higher inflation will not have significant long-lasting negative impacts.

While Krugman initially claimed that inflation as a result of covid response strategies alongside massive quantitative easing (QE) efforts would not even exist, we are now being bombarded with claims that it is temporary or even good for us. Both claims, however, come from a fundamental misunderstanding of the essence of inflation. For this, we look to Mises, who described the phenomenon in the following way: “Inflation is an increase in the quantity of money without a corresponding increase in the demand for money.”

For Krugman, the inflation seen today comes from the interplay of two sources: 1) returning consumer demand catalyzed by fiscal stimulus and 2) supply-chain issues exacerbated by a mass departure of workers, coined the “great resignation.”

His analysis is technically correct, but grossly misleading. For one, Krugman fails to mention how his first point is causal to the second. Strong fiscal stimulus and the effects of lockdowns contributed to dramatic reductions in labor force participation, which have not since recovered.

US consumers are working less and spending more, effects of lockdowns and stimulus. This is reflected strongly in the US merchandise trade deficit, which reached an all-time high of $96.3 billion in September of this year. Still, despite massive job openings, labor force participation remains nearly 3 percent lower now than in January 2020. In fact, current data suggests that the labor force participation rate has plateaued well below precovid levels. Also note that monetary policy is nowhere mentioned in Krugman’s analysis.

In a normal world, higher wages, massive job openings, and market highs would justify raising interest rates. However, for the Federal Reserve, which continues to flood markets with liquidity, the present-day notion of an interest rate hike is farfetched.

Bond markets price the next increase in interest rates to come once quantitative easing programs are completely eliminated. QE programs are being tapered at a rate of $15 billion per month from their current monthly level of $120 billion ($80 billion in Treasurys and $40 billion in mortgage-backed securities). At that rate, the QE program would be completely eliminated in eight months. However, there is no evidence that this elimination of QE is certain.

In 2008 the Fed made similar remarks about unwinding asset purchases. Regardless, four rounds of QE were undertaken between November 2008 and September 2012 before it finally came to an end. In reality, this most recent round of QE is much stronger than ever before, as central bank enabled spending is becoming more of the norm. Markets should therefore take what the Fed has to say with a grain of salt.

Importantly, the Fed’s tapering of bond purchases does not reduce inflation, but instead reduces the rate of increased price inflation. Bond purchases are cumulative and therefore each purchase adds to the overall money supply; by simply reducing the rate of these purchases, we do nothing to slow inflation, it simply means we are inflating at a slower rate—prices still rise.

If the Fed were to get serious about slowing inflation, not only would it divest from bond purchases completely, but it would also engage in the active sale of securities to reduce its unprecedented balance sheet which boasts over $8 trillion of assets, representing more than a staggering one-third of gross domestic product (GDP).

Krugman also points to another reason why we might be seeing inflation today: real final demand is up 2.6 percent in the past two years, therefore, even adjusted for inflationary effects, people are consuming more than they were precovid.

Yet it is not so obvious how increased consumption backs his claim that inflation is more likely than not to be transitory. As a function of GDP, personal consumption expenditures are hovering around an all-time high at 68.8 percent of GDP in the third quarter of 2021. Conversely, personal saving rates have collapsed to 2019 levels of 7.5 percent after the initial bump from fiscal stimulus. This, of course, makes sense in the era of ultralow interest rates. All expectations suggest that interest rates should remain near these all-time lows even if marginal interest rate hikes are implemented. Contra Krugman’s analysis, this should add to long-term inflationary pressures, not reverse them.

Lastly, let us consider the Producer Price Index (PPI) which measures the costs of domestic production over time. Precovid, the index was just under two hundred points; today that figure is approximately 20 percent higher, at 240 points.


The significance of the PPI cannot be understated. One reason in particular why the Consumer Price Index (CPI), which comes in “only” at 6.2 percent, and the PPI may be so different is that US consumers are importing from other countries, thereby keeping their costs lower, hence the ballooned merchandising trade deficit this year. The cost of this, however, will be reflected in real GDP, which declines with greater trade deficits.

With an increasing PPI, US exports become less competitive relative to imports. As such, the real value of exports, adjusted for inflation, has declined sharply, by nearly $250 billion (in chained 2012 US dollars), since the beginning of 2020 despite massive government subsidies for producers and the $500 billion in loans given out in the CARES Act to corporations.


In the greater context of the US trade balance, with rising imports and declining exports, the US trade deficit is at a multiyear record of roughly $81 billion.


It is now clear that the CPI’s headline inflation rate may be depressed due to a rising trade imbalance between US and global markets. Once this pressure is alleviated, through declines in real GDP and a weakened US dollar, the CPI number will likely catch up to the PPI numbers. In the near to long term, foreign imports cannot endlessly fund overconsumption. Therefore, future inflation may not only be persistent but getting stronger, as access to cheaper imports will have to lessen with a weaker dollar.

If it were truly the case that the inflation seen today is largely due to supply chain bottlenecks, it would not concur with the fact of growing trade deficits. In fact, US consumers would purchase US products instead which have less logistical reliance on global supply chains than imports. This, however, is clearly not the case.

To summarize the fact pattern of inflation presented in this article: 1) The US economy is consuming more and producing less. 2) Consumers are importing from other countries to fill the gap between higher consumption and lower production. 3) Producer prices have skyrocketed; however, since consumers are becoming more reliant on imports, the extent of this rise is not immediately seen in the CPI. 4) Rising trade deficits will bring down the US GDP and erode the purchasing power of the US dollar. 5) The Fed may eliminate bond purchases after some months; however, this will not reduce inflation, but only add to it at a lesser rate.

For Krugman, these facts may be irrelevant. Yet this is precisely why his past predictions have been so far unable to properly gauge inflation. Once these previously missing variables are considered, his analysis may have a more principled approach. That is, clearly, the supply of money has dramatically risen, while the demand for it has failed to keep up.

  • 1. In this article, when I use the term "inflation," I mean price inflation and not monetary inflation.
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