John Cochrane on Inflation, Fiscal Space, and the Risks of the Next Crisis

Can the Fed fight inflation without fiscal reform?

Economist John Cochrane has just released a major new NBER working paper, “Monetary–Fiscal Interactions” (September 2025). It brings the fiscal theory of the price level (FTPL) directly to bear on the inflation surge of 2021–23. At its heart, the paper makes a simple claim: The great inflation we just lived through was a fiscal event, not a monetary one. The government borrowed and spent trillions with no credible plan for repayment, and bondholders responded by fleeing into goods and services, driving up prices until the real value of federal debt was deflated back into line with what taxpayers were expected to cover.

Cochrane is not simply rehashing past arguments. He is also issuing a stark warning: Unless fiscal policy tightens meaningfully, higher interest rates will no longer be sufficient to control inflation. In fact, higher interest rates may exacerbate inflation by exploding debt service costs. The loss of “fiscal space” means the next crisis could look very different from the last.

Inflation as a Fiscal Shock

Cochrane starts with the facts. Inflation broke out in early 2021, just as trillions in new federal spending, layered on top of pandemic relief, hit the economy. The Fed kept rates at zero for a full year, but inflation did not spiral. By mid-2022, inflation began easing even though interest rates were still below inflation and no recession had occurred. For the standard New Keynesian model, this was a puzzle: The Fed had not imposed the painful 1982 Volcker-style interest rate shock usually deemed necessary.

For the fiscal theory of the price level, however, the episode is textbook. Inflation results when the present value of government surpluses falls short of the debt outstanding. Put differently: If markets doubt that future taxes will cover today’s deficits, the price level adjusts until the real value of debt falls to match expected repayment. That is exactly what happened between 2021 and 2023.

Cochrane contrasts this with the 2008–09 years, when massive deficits did not produce inflation. The key difference, he argues, was credibility. Following the Great Financial Crisis, policymakers at least gestured toward fiscal repair. In 2009, President Obama pledged to cut the deficit in half. As the chart below demonstrates, by 2014, budget deficits were back to pre-crisis levels. In 2020-22, the CARES Act, American Rescue Plan, the CHIPS Act and the so-called Inflation Reduction Act signaled the opposite: Deficits were not temporary but rather structural. No commitments were made to repay the $5 trillion in additional borrowing.

Monetary Policy Alone Is Not Enough

Cochrane then tackles the second puzzle: Why did inflation subside without a crushing recession? In Cochrane’s model, once the one-time fiscal shock has run its course and the real value of debt has been reduced through inflation, the upward pressure on prices dissipates naturally. Interest rate hikes can speed the adjustment, but they are not strictly necessary.

The conclusion is unsettling: Interest rates do not determine inflation on their own. Their effectiveness depends on fiscal backing. Higher real rates mean higher debt service costs. At today’s debt-to-GDP ratio near 100%, each percentage point rate increase adds roughly 1% of GDP to the annual deficit. If those costs are not offset by higher taxes or lower spending, they are themselves inflationary. Monetary policy cannot tighten in a fiscal vacuum.

Lessons from the 1980s

Many economists will point to Fed Chair Paul Volcker’s campaign in the early 1980s as proof that aggressive monetary policy can defeat inflation. Cochrane is more cautious. Yes, rates rose above 15%. Inflation fell. But this was not simply a triumph of monetary policy. It was a joint effort: Fiscal reforms — including Social Security reform, sweeping tax reform and deficit reduction commitments — deregulation and higher growth all boosted the present value of future surpluses. Taxpayers ultimately bore the cost of higher real rates and windfalls to bondholders. Without that fiscal adjustment, he argues, Volcker’s tightening could not have stuck.

Here is the rub: In 1980, federal debt was just 25% of GDP. Today, it is 100%. The fiscal room to support another Volcker-style disinflation simply does not exist.

Why This Matters Going Forward

Cochrane’s biggest concern is not the steady upward creep of the debt ratio. It is the next financial crisis. The recent debt surges of 2008 and 2020 were crisis driven. In the next downturn, or geopolitical shock, policymakers will again be tempted to spend trillions. But bondholders, already burned by the inflation of 2021–23, may be less forgiving. If investors conclude the U.S. has no credible path to repayment, inflation could return faster and more violently than before.

This is why “fiscal space” matters. The U.S. can sustain high debt if investors trust that surpluses will eventually materialize. Without that trust, however, even moderate deficits can be destabilizing. Structural entitlement reform and pro-growth policies are therefore essential not only for long-run solvency but also for inflation control.

Policy Implications

Cochrane’s argument might be controversial. Monetarists will bristle at his dismissal of money supply measures, and Keynesians will insist that supply shocks mattered more than Cochrane admits. But his fiscal perspective captures something the others miss: Inflation is ultimately about government solvency. If deficits are perceived as unbacked, prices will rise until debt holders have absorbed the loss.

For me, the key takeaway is how fragile the next decade looks. With public debt already at 100% of GDP — heading toward 130% — entitlements left unreformed and political consensus on deficit reduction absent, the fiscal foundation for stable prices is weak. A future crisis may expose that weakness brutally.

The policy implication is clear: Inflation control cannot rest on the Fed alone. It requires credible fiscal policy. That means smaller structural deficits, entitlement reforms and pro-growth policies that expand the tax base without higher rates. Without those, interest rate hikes may only stoke the very inflation they are meant to fight.