What Drives Inflation Now? A Clear Explanation Using Mervyn King, John Cochrane, Stephen Miran and Kevin Warsh’s Competing Ideas

For decades, central banks such as the Federal Reserve and the Bank of England have told a reassuring story. Set an inflation target, usually two per cent. Move interest rates up or down around that target. Use careful language at each meeting. If the public trusts the process, inflation will return quietly to where it is supposed to be.

It sounded scientific. It sounded controlled. It sounded like somebody had a map.

The uncomfortable reality, admitted now in academic lectures by former insiders like Mervyn King, is that the map no longer fits the terrain. The old theory of inflation does not explain what happened after 2008, and it does not explain what happened when prices jumped again after the pandemic. The compass has been spinning, yet the same people still claim to be guiding the ship.

How the old story collapsed

The traditional narrative rested on two supports. The first came from Milton Friedman: inflation is “a monetary phenomenon”. If you create too much money, prices will eventually rise. The second came from modern central bankers such as Ben Bernanke and Janet Yellen: if people trust that the central bank will keep inflation at two per cent, their behaviour will help deliver that outcome.

Both pillars have cracked. In the banking system that Friedman wrote about, central banks had a much tighter grip on the money supply. In the system Mervyn King and his successors actually had to manage, most so called money is created by private banks, shadow lenders and complex credit structures. The amount, and the speed at which it moves, change in ways that are hard to observe and harder to predict.

Then came the stress test. After the 2008 crisis, central banks slashed interest rates close to zero and bought vast quantities of assets. Their balance sheets swelled by trillions. According to the simple story, that should have produced a surge in inflation. It did not. For years the worry was not runaway prices but stubbornly low inflation.

When inflation finally did spike after the pandemic, it did not follow the script either. The surge followed supply shocks, lockdowns, war, energy prices and fiscal packets, not a neat chain from the policy rate to wages and then to prices. The very theory that had been used to justify decades of central bank independence could not explain the world that had actually unfolded.

The monetarists: when money no longer means one thing

The first camp still tries to read inflation through the lens that Milton Friedman used. On this view, central banks that expand their balance sheets dramatically should expect higher prices. It is an attractive idea, because it gives the central bank a starring role and a simple tool.

The difficulty is that the concept of “money” has blurred. Private banks extend credit through lines, swaps and securities that behave like money without ever appearing clearly in the old aggregates. Shadow banking, repo markets and derivatives amplify this. The connection between the quantity of base money created by the central bank and the price level in the wider economy has become weak and unstable.

Monetarism does not disappear. It still tells part of the story. But it no longer gives a reliable guide for policy makers who need to know what will happen next year, not just over an entire decade.

The fiscal realists: John Cochrane and the debt story

The second camp, associated with John Cochrane, looks not at the central bank balance sheet but at the government ledger. This is the fiscal theory of the price level. In plain words, it says that inflation is how the state brings the real value of its debts into line with what it can honestly deliver in future surpluses.

If a government keeps running large deficits, and voters or markets do not believe the promises about future restraint, then something has to adjust. The state can raise more tax, cut spending, default outright, or allow prices to rise faster so that the real weight of the debt falls. Inflation, in this view, is not an accident. It is a political choice about who loses.

The fit with our time is suggestive. Ageing societies drive pension and health costs higher. Security tensions drive defence budgets higher. Tax rises are politically toxic. At the same time, sanctions and the freezing of reserves have made foreign creditors question how safe it is to hold their savings in Western markets. Cochrane’s frame captures that stress more directly than the old central bank stories.

The expectations regime: belief as a policy tool

The third camp is the one that still dominates the daily work of central banks. It says that what really matters is not the exact structure of the banking system or even the fiscal position, but what people believe will happen. If workers and firms trust the Federal Reserve to keep inflation close to two per cent, then they will set wages and prices in that range, and the belief becomes self reinforcing.

Under this regime, the inflation target becomes the main instrument. The central bank announces it. It behaves in ways that are meant to be consistent with it. It talks constantly about it. As long as expectations seem steady, it assumes reality will fall in line.

Mervyn King’s criticism is precise. He does not deny that expectations matter. He argues that the profession started to act as if the target itself were a mechanism, rather than a constraint. The two per cent figure was meant to discipline policy in a world of uncertainty. Instead it became a sort of mantra. When inflation finally broke away from target, the gap between the neat story and the messy world was exposed.

The Federal Reserve factions: Miran, Warsh, Waller and Hassett

The struggle over who should run the Federal Reserve has brought these theoretical cracks into the open. The key names are Stephen Miran, Kevin Warsh, Christopher Waller and Kevin Hassett, each standing in for a different answer to the inflation question.

Stephen Miran argues that the usual models misread the present. He says that regulation, capital rules and the way reserves are treated now dominate how monetary policy works. He calls this regulatory dominance. In his view, the policy stance is tighter than the headline interest rate suggests, standard inflation data are backward looking and distorted, and the Fed could cut rates more aggressively without igniting a new price spiral.

Kevin Warsh takes almost the opposite view. For him, inflation is essentially a choice. He argues that the Fed has allowed itself to drift away from a strict price stability mandate and has become too entangled with fiscal policy and asset prices. The solution, in his language, is to narrow the remit of the central bank, unwind exceptional measures and treat overshoots of the target as failures, not tolerable noise.

Christopher Waller represents the more traditional insider stance. He speaks the language of data dependence and anchored expectations. He accepts that the relationship between unemployment and inflation has changed, but still behaves as if careful moves in the policy rate around a two per cent target remain the main instrument.

Kevin Hassett, aligned with Donald Trump, has argued on television for rate cuts and emphasised the growth side of the mandate, but has not set out a detailed monetary framework that can be tested on its own terms.

The missing element: power, debt and who pays

There is one thread that pulls these arguments together and explains why the theory gap matters. Inflation is not just an economic variable. It is a way of deciding who absorbs loss when a political system runs out of easy options.

Governments have promised more than they can comfortably finance. Ageing and health costs are high. Defence and security demands have risen. Voters resist tax rises. At the same time, the freezing of Russian reserves, the disputes over Venezuelan gold and the wider sanctions regime have made other states question whether their savings are safe in Western custody. That doubt translates over time into weaker demand for government debt.

In this environment, the three main ways to close the gap are simple. Raise taxes. Default outright. Or let inflation run above target often enough, and long enough, that the real value of the debt falls. The third option is the least visible day to day. It is also the one that best fits the political incentives of debt heavy states.

Central banks then become managers of this adjustment. They raise rates enough to signal discipline and avoid panic, but not enough to force a brutal reckoning. They tolerate periods of above target inflation while insisting that expectations remain anchored. They present their decisions as technical responses to data, even when those decisions align with the fiscal needs of the state.

Why this matters for the rest of us

All of this might sound abstract, but you see the results every time you shop or look at your mortgage statement. Inflation decides whether wages keep pace with prices. It decides whether savings hold their value. It influences house prices, rent, pensions and the viability of small firms.

When figures like Mervyn King say that central banks no longer have a working theory of inflation, they are saying that the tools used to justify these redistributions no longer have a solid intellectual base. When Stephen Miran, Kevin Warsh, Christopher Waller and Kevin Hassett give four different accounts of what the Federal Reserve should be doing, they are revealing that the profession itself is fragmented.

The purpose of simplifying this debate is not to reassure. It is to make the stakes visible. If inflation is increasingly a political instrument, used in a world of strained budgets and weaponised reserves, then it should be treated as such. Not as a neutral side effect of technical choices, but as a deliberate, if often unspoken, way of deciding who pays.

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