Expectations, Policy, and the Anatomy of Recent Inflation

There is a version of the 2021–24 inflation story that goes something like that: a once-in-a-generation pandemic collided with a war in Europe, supply chains seized up around the world, and prices rose in ways that no one could have anticipated or prevented. The Federal Reserve eventually acted, inflation came down, and we should be grateful it wasn’t worse.

This story is not entirely false. The shocks were real. But a new paper by Ricardo Reis of the London School of Economics adds more fuel to the fire that this version doesn’t hold water, and in fact, leaves out the most important part. The inflation surge was not primarily a supply shock (sorry team transitory). In Reis telling, it was the predictable consequence of specific choices, operating through mechanisms that were knowable in advance, that could have produced different outcomes under different policy rules.

That should make us uncomfortable. Because the conditions that made it possible have not gone away.

Reis starts by explaining why the shock account misses the point. He begins with a deceptively simple observation: listing the shocks behind an economic event is useful, but it is the wrong level of analysis for anyone seeking actionable insights. Shocks cannot be prevented. What policymakers can control is how institutions respond to shocks and crucially, how clearly they signal that response to everyone else because those signals shape expectations, and expectations shape outcomes.

The conventional account of the inflation surge, laid out by Fed Chair Powell at Jackson Hole in 2024, names the right shocks in roughly the right sequence: pent-up consumer demand, fiscal stimulus, supply chain disruptions, energy prices after Russia’s invasion of Ukraine, and eventually the Fed’s rate hikes bringing prices back down. Reis accepts this sequence. What he argues is that it conceals the more interesting question: why did those shocks, which hit multiple countries simultaneously, produce so much more sustained and severe inflation in some places than in others? And why did the same shocks that would have caused a modest recession and a small price increase under the policy framework of the 2000s instead produce the largest inflation surge in four decades?

His answer is that the shocks were the spark, but what turned them into a sustained fire was a shift in what people expected governments and central banks to do. When households anticipated that stimulus would continue, they kept spending. When firms anticipated that the Fed would tolerate higher prices, they raised them. When financial markets saw the deficit expanding without any monetary response, they priced in more inflation, which itself fed more inflation. The fuel, in other words, was not simply money sloshing around the economy. It was the beliefs that fiscal and monetary policy had become less committed to price stability, and the self-fulfilling dynamic those beliefs set in motion. Containing the fire required not just raising interest rates, but restoring the credibility that anchors expectations in the first place.

Reis identifies four channels through which the inflation surge was transmitted and amplified. Financial markets began to doubt the Fed’s commitment to its target, pushing long-run inflation expectations up by nearly a percentage point, though decisive tightening in 2022 prevented this from spiraling into a 1970s-style unmooring. More strikingly, a pre-pandemic Phillips curve model predicts the entire rise and fall of inflation almost perfectly once household and firm expectations are included, and supply shock measures add nothing once those expectations are accounted for, suggesting that disruptions like supply chains mattered mainly by raising people’s price expectations, not as independent drivers. Across countries, fiscal deficits that overshot pre-pandemic projections produced a disproportionate amount of unexpected inflation, with roughly a quarter of the excess spending ultimately inflated away rather than repaid. Finally, the Fed’s own published projections reveal that in 2021, policymakers were implicitly willing to tolerate elevated inflation in a way that departed sharply from their pre-pandemic behavior, effectively accommodating the fiscal expansion rather than resisting it.

I see things a little differently. In my understanding, inflation is not primarily a story about expectations shaped by monetary policy and expectations that the Fed could have controlled but it is a direct consequence of perceived fiscal imbalances with no credible fiscal backing coming in the future. When governments issue debt and people expect it cannot credibly repay through future surpluses, the price level rises to restore equilibrium. Reis’s third mechanism, the cross-country relationship between fiscal overruns and unexpected inflation is not merely corroborating evidence but the central result, and the other three mechanisms are downstream of it.

In the end, one of the paper’s most significant contributions is what it does to the recent supply shock narrative. It is also consistent with Jack’s own review of the literature on the issue. Supply disruptions weren’t irrelevant, but they weren’t the primary cause of the inflation we just went through.

There is a lot more to say about this paper, but I will let you read it.

Why does it matter now? Well, the inflation of 2021–24 has largely been resolved. Prices are no longer rising at the rate they were. There is an understandable temptation to treat the episode as closed. Reis’s paper resists that temptation, and so should we. The conditions that produced the surge have not disappeared. Public debt in advanced economies is at historically high levels and rising. Political systems have clearly and recently demonstrated their willingness to accommodate large fiscal expansions regardless of the consequences. The Federal Reserve’s credibility was built over three decades and was partially spent during this episode. And the scars in financial market expectations mean that the next fiscal shock will face a less forgiving starting point.