What Really Drives Inflation
— September 11, 2020
By Itamar Drechsler, Alexi Savov and Philipp Schnabl
The obvious question arises: won’t the Fed’s new framework squander its hard-won credibility and trigger runaway inflation? The Fed is now explicitly promising to let inflation run above target unchecked. Under the perceived wisdom of the Great Inflation, this could lead to an inflation spiral. With record federal deficits and a massive Fed balance sheet, shouldn’t we worry? These concerns were echoed in two recent VoxEU columns by Olivier Blanchard (2020) and Charles Goodhart (2020).
In a new paper (Drechsler et al. 2020), we offer a different explanation for the Great Inflation – why it began and why it ended – that provides an answer to this question. The explanation is simple, yet so far completely overlooked. It centres on an important law known as Regulation Q. Regulation Q placed hard ceilings on the interest rates banks were allowed to pay their depositors. This meant that no matter how high the Fed raised interest rates, it made no difference to most people. The transmission of monetary policy through the financial system was broken. This is what made inflation get out of control. And it was the repeal of Regulation Q at the end of the 1970s that brought inflation to heel.
Read the full Vox EU article.
Alexi Savov is an Associate Professor of Finance. Philipp Schnabl is the Martin J. Gruber Professor in Asset Management and Professor of Finance.