Why Fighting Inflation May Now Be Making It Worse
By editor@theschism.org — 2026 update
This reflects a re-write of an earlier article at The Schism from 2023, which has generally been borne out by the economic data over the last 3 years.
Stagflation will return … especially if we try to prevent it! –
Central Banks, and the trusty hammer
In 2023, as inflation re‑emerged across advanced economies, central banks reached reflexively for the familiar tool: tighter monetary policy. Interest rates rose rapidly, justified by the orthodox claim that inflation is always and everywhere a demand problem — and that credibility, once reasserted, would do the rest.
Three years on, that confidence looks increasingly fragile.
While higher rates have slowed growth and weakened labour markets, inflation has proven more persistent than expected — particularly in services and margins — and corporate profitability has remained remarkably resilient. This combination should prompt a re‑examination of a long‑held assumption: that monetary tightening is a universally effective inflation‑busting tool.
It is not.
In some macroeconomic conditions, tightening monetary policy does more than fail — it actively creates the conditions for stagflation. The post‑2020s economy increasingly resembles one of those conditions.
A brief history of inflation regimes
To understand why, it is useful to step back and look at inflation through a longer structural lens. Over the past 65 years, three distinct regimes stand out.
Period 1: 1960–1981
A prolonged episode of rising and volatile inflation, punctuated by repeated tightening cycles that suppressed demand temporarily but failed to arrest the underlying inflation trend.
Period 2: 1982–2010
An era of relatively stable inflation in which monetary policy appeared highly effective. Business cycles were smoothed, inflation expectations anchored, and central banking emerged as the dominant macroeconomic stabiliser.
Period 3: 2011–present
A transitional phase in which inflation re‑emerged after a long dormancy — first tentatively, then forcefully after the pandemic — and has proven resistant to conventional policy responses.
Orthodox macroeconomics attributes the success of Period 2 largely to the triumph of credible monetary policy, epitomised by the Volcker disinflation. Yet this explanation struggles to answer two basic questions:
- Why did similar monetary tightening repeatedly fail in Period 1?
- What changed structurally around the early 1980s that made monetary policy suddenly decisive?
If we are to avoid repeating past errors, we need a more complete theory of inflation than “rates up, prices down”.
Inflation has multiple causes — and only some respond to rates
Monetary policy works by suppressing demand. It reduces disposable income, discourages borrowing, and reshapes expectations about future spending. As a counter‑cyclical tool, it can be effective — when inflation is demand‑driven.
But inflation is not monolithic. At least three distinct mechanisms matter:
- Demand‑pull inflation driven by overheated consumption and investment.
- Supply‑side inflation caused by disruptions, bottlenecks, or input shortages.
- Structural inflation arising from disequilibrium in capital markets.
Monetary tightening can address the first. It can partially offset the second by shrinking the economy to fit temporarily constrained supply. But when the third dominates, tightening becomes self‑defeating.
It is this third mechanism — structural inflation driven by capital‑market imbalance — that is most often overlooked, and most dangerous.
Capital markets and inflation: the missing link
Standard economics teaches that inflation occurs when demand for goods exceeds the ability to produce them. What is less appreciated is that “goods” include not only consumption goods, but claims on future income — that is, capital.
When the economy cannot generate a balance between:
- aggregate income,
- aggregate capital,
- and the return demanded by capital,
inflation can emerge even without excess consumer demand.
A useful way to think about this is through the capital‑to‑income ratio — the stock of accumulated capital relative to the flow of income that must service it.
Inflation behaves very differently depending on whether this ratio is near:
- a nadir (capital scarcity), or
- a zenith (capital glut).
The 1970s: capital scarcity and stagflation
In the late 1960s and 1970s, advanced economies operated near a capital‑ratio nadir. Highly progressive taxation, combined with institutional constraints on profitability, limited the private sector’s ability to accumulate financial capital.
The result was not merely redistribution, but capital starvation. Firms struggled to finance expansion, supply capacity lagged demand, and inflation emerged from the supply side of the economy.
Crucially, tightening monetary policy in this environment did not cure inflation. It:
- suppressed demand temporarily,
- raised business financing costs,
- further reduced profitability,
- and worsened the underlying supply constraint.
The outcome was the familiar see‑saw of the era:
- recessions induced by tightening,
- inflation rebounds once policy was relaxed.
That pattern has a name: stagflation. Monetary policy did not defeat it — it helped create it.
Inflation was only brought under control once structural policy changed in the early 1980s: tax progressivity fell, capital accumulation recovered, and supply capacity expanded. Monetary policy alone did not tame inflation; it merely became effective once the underlying capital constraint was removed.
The long calm — and what made it possible
From roughly 1982 to 2010, the global economy occupied a sweet spot. Capital markets were deepening, but not yet saturated. Capital accumulation provided the required investment to fund growth, and as it held unequally, inequality increased as savings increased. And a larger proportion of capital income going to a small proportion of savers at the top of the income and wealth distributions meant that the demand for goods and services did not increase in proportion with the increased savings. (Differences in marginal propensity to consume skewed the share of economic activity funding savings, rather than supporting consumption.)
Falling returns absorbed the pressure during this period.
As capital accumulated faster than aggregate demand (and aggregate income), the rate of return on capital declined steadily. This adjustment allowed the system to remain in equilibrium without driving changes in prices or profit shares.
During this period:
- inflation shocks were cyclical or temporary,
- monetary policy worked as advertised,
- and central bankers mistook a historically contingent success for a universal law.
That calm has now ended.
The post‑2010s: capital abundance and a new inflation dynamic
By the early 2010s, the long decline in returns on safe capital approached a practical floor. Once risk‑adjusted returns turned marginal or negative, capital markets could no longer equilibrate simply by lowering yields.
At that point, the system faced a choice:
- Reduce the capital share of income through policy — higher wages, higher taxes on capital, or redistribution.
- Force higher nominal returns through pricing power, mark‑ups, and profit expansion.
In the absence of decisive policy intervention, markets predictably chose the second.
This shift explains several features of the post‑pandemic inflation episode that orthodox models struggle with:
- persistent corporate margins,
- weak wage pass‑through,
- inflation concentrated in services and mark‑ups,
- and the resilience of profits even as growth slowed.
What is often dismissed as “price gouging” is better understood as capital enforcing a non‑zero return floor in a saturated capital environment.
Why tightening now risks stagflation again
Monetary tightening does not reduce the stock of capital, nor does it alter capital’s claim on income. What it does do is:
- raise financing costs,
- weaken labour’s bargaining position,
- suppress demand,
- and increase pressure on firms to maintain margins.
In a capital‑abundant economy, firms respond rationally: by cutting labour, protecting profits, and passing costs forward. Inflation does not disappear; it is merely reshaped.
The result is eerily familiar:
- slowing growth,
- rising unemployment,
- inflation that recedes temporarily but rebounds once policy eases.
In other words, stagflation dynamics re‑emerge — not as a carbon copy of the 1970s, but as a modern, margin‑driven variant.
A counter‑intuitive policy implication
Once capital abundance becomes the dominant inflation driver, monetary policy alone cannot restore price stability. Worse, it can entrench the problem.
Stabilising inflation in this environment requires addressing the underlying disequilibrium:
- excessive savings relative to income,
- an elevated capital share,
- and insufficient demand absorption.
That points — counter‑intuitively — toward:
- greater fiscal activism,
- higher tax progressivity,
- policies that rebalance income toward labour,
- and public investment that absorbs surplus savings without inflating asset prices.
This does not mean abandoning monetary discipline altogether. Demand‑pull inflation still exists, and supply disruptions still matter. But central banks must recognise that not all inflation is demand‑driven, and that applying the wrong tool can make matters worse.
The real risk
The real danger in 2026 is not runaway inflation per se. It is the quiet re‑normalisation of a world in which:
- growth is weak,
- employment is fragile,
- profits are protected,
- and inflation never quite dies.
That world has a name. We have been there before.
If we try to prevent stagflation with the wrong tools, we may yet succeed — in bringing it back.