The Rabbit-Duck Question: What Caused the Recent Inflation Surge?

The rabbit-duck drawing has gathered the attention of psychologists and philosophers for more than a century. It portrays an animal that can be a rabbit or a duck, depending on how you look at it. Some people only see the rabbit, others only see the duck, and still others switch back and forth and see one or the other (though usually not both simultaneously).

As inflation has surged and receded, debate has raged about its causes. As with the famous rabbit-duck figure, different observers see the same picture in different ways. Regarding inflation, the problem is compounded by there being (at least) three perspectives instead of two:

• Firm decisions, as firms demand higher prices when responding to increasing logistical costs, tightening labor market conditions or more pliable consumers
• Central bank decisions, as central banks can react more or less forcefully to economic developments, influencing how much inflation occurs
• Government debt decisions, as government debt surged due to the various forms of pandemic assistance and perspectives for future fiscal adjustment

Public debate has tried to distinguish between those views with different heuristics. Sectoral variation in price changes may correspond to the varying motivations of different business owners, as they are subject to different cost pressures. At the same time, the permanent price increase in response to temporary cost pressures may suggest to some a role for equally permanent (nominal) debt accumulation. Finally, the return of low inflation as unemployment stays low may give the impression that monetary tightening had little role in inflation control.

Unfortunately, as we will see, those simple heuristics cannot distinguish among the alternatives. In part, this is because (like the rabbit-duck drawing) the surge in inflation can and should be interpreted from all of those perspectives simultaneously, and evidence for one mechanism does not exclude the others. While it is easier to hold one perspective at a time, an analysis of the last few years would be well advised to keep apprised of each of these views.

The debate among perspectives gathers attention because each perspective seems to imply different policies. A firm-centered view may suggest that inflation control would be achieved through measures to ease supply pressures or even control prices. Views centered on the central bank or government debt would imply a central role for monetary and fiscal policies, respectively.

While all perspectives are based on true underlying economic forces, different policies to keep inflation in check have different costs and benefits. In some cases, the costs may become prohibitive. Focusing on those policy trade-offs is more fruitful than insisting on one perspective at the expense of the others.

In what follows, I will describe the three perspectives, the arguments made to prioritize them and how those arguments fall short. In the end, I will provide some thoughts about how they connect and how considering those connections may lead us to understand better what happened and the relevant policy trade-offs.

The Firm Perspective on Inflation

Prices are decided by firms, either alone or in negotiation with their customers. The simple observation that prices are chosen by firms has led many to blame them for inflation. In this view, corporate greed causes price instability, especially if firms sense that they can increase their markups with little resistance from consumers. A more business-friendly version of this perspective has emphasized the role of dislocations in the prices of key inputs after the pandemic, notably shipping costs, microchips and energy.

Under both interpretations, the explanations for inflation would center on the decisions and pressures felt by firms. Inflation control would, therefore, involve policies focusing on reining in firm decision-making and mitigating the cost pressures they face.

The notion that prices are set by profit-maximizing firms is at the core of modern models of inflation. Firms understand that charging higher prices reduces the demand for their products. Therefore, they balance the gains from higher revenue per unit sold with the losses from lower sales.

In addition, they consider that they may be unable to change their prices easily for prolonged periods. Therefore, pricing decisions also must account for how their costs will likely increase in the future, for reasons including persisting inflation.

Evidence for those narratives might be gleaned from firm or sectoral-level data.¹ As firms are subject to different degrees of cost pressure or competition, one might expect different pricing reactions. The problem with any such analysis is that it reveals how firms in a given industry choose their prices relative to those of their competitors and suppliers. Inflation, however, is the change in all prices in the economy.

At the same time, a lack of difference across firms or industries is not evidence that firm-level decision-making isn't central to inflation dynamics. Firms are linked to each other through supply chains, and workers demand higher wages as inflation rises. Therefore, faster price increases in certain parts of the economy may lead to price increases everywhere else, sometimes over and beyond what would be implied by the initiating shocks.²

The firm-centric view does not imply that attempting to control prices is good policy. Models with price-setting choices modify earlier Walrasian theory, in which firms operate under perfect competition and have no pricing power.

While those models are unsuitable (without modifications) to study inflation, they contain important lessons that also apply when firms have market power. In particular, they imply that correct relative prices are central to ensure that production is done most efficiently (so that maximal output can be produced with the least effort) and that goods are not in systemic shortages and gluts.

The latter prediction aligns with the casual observation that, unlike planned economies, market economies rarely feature empty shelves and long lines for day-to-day goods. In contrast, attempts at controlling inflation through direct price controls have (at best) a mixed record. Price controls tend to backfire, often keeping prices of certain goods too low and leading to shortages of those goods. In response, sales start taking place in informal markets or are directed towards other goods whose prices may increase more rapidly. Eventually, the situation becomes untenable, leading to even stronger inflation as price controls are lifted and repressed prices catch up with their market values.³

This seems to imply a "Catch-22." The proximate cause of inflation is firms' pricing decisions. Still, it is virtually impossible to directly intervene in those decisions without affecting relative prices, which are central to the good functioning of a market-based economy. Also, those interventions appear to have limited ability to rein in inflation for very long.

For those reasons, the Federal Reserve and other modern central banks try to keep their intervention minimalistic. For a long time, the Fed intervened in a single market to influence a single price: the nominal interest rate on overnight loans. Since the global financial crisis, central banks have expanded their instrument menus but have tended to stick to financial interventions in low-risk markets.

The Monetary Policy Perspective of Inflation

The second perspective focuses on central banks and monetary policy. Firms seek higher price changes relative to their normal rates if the economy is booming and will refrain from doing that in a recession. By setting interest rates, central banks can regulate whether the economy is in a boom or recession and, as such, affect pricing decisions.

The key factor in the reasoning is the realization that central banks have almost full discretion to set nominal interest rates and a reasonable amount of power to set real interest rates, at least over short-to-medium horizons. For example, in the U.S., the Fed can choose how much interest to pay on its reserves or the discount rate that it offers to banks as an administrative matter.

From that perspective, lower inflation can happen if the central bank raises interest rates, potentially generating a recession and preventing firms from raising prices. If the central bank can credibly communicate a commitment to fight inflation, a recession may not even be necessary.

Firms set prices in a forward-looking manner, knowing that their prices may stay in place for some time. If these firms understand that the central bank will fight any coming inflation with higher interest rates, they may conclude that raising prices is not worth it even before that comes to pass.

It follows that, in this view, any inflation is a consequence of central banks not sufficiently committing to price stability. While possibly correct, this leaves the question of whether central banks should completely commit to price stability at all times. In the U.S., the Fed has a dual mandate, meaning that it should also seek maximal employment. More generally, fighting inflation in the face of cost pressures coming from supply chain disruptions or tariffs may be doable but not advisable.

In 2021, many observers perceived that cost pressures would eventually subside and that central banks would be best served by not reacting too strongly and letting those pressures work themselves out through inflation. In more technical terms, one may suggest that supply chain shocks could be just a "relative price" shock without inflation consequences if central banks choose that to be the case.

The main issue is that raising interest rates to avoid inflation has a cost. Higher interest rates burden firms and households, as does the ensuing recession. Therefore, a main question central banks face is: At what point do those costs exceed the gains from price stability?

Lastly, central banks may be less powerful than the discussion above suggests. Inflationary pressures may come from increasing government debt, in which case higher interest rates would be like adding fuel to the flames. This is the basis for the last perspective, which emphasizes the role of government debt and the government budget constraint in driving inflation.

The Government Debt Perspective on Inflation

The pandemic's impact on government finances was comparable to a major war.⁴ For months, governments all over the world paid their citizens — through direct transfers, extraordinarily generous unemployment insurance programs or assistance to firms — to stay home to avoid transmission of COVID-19. This assistance combined with various programs designed to help businesses, hospitals, schools and various parts of society function led to a surge in the national debt.

One perspective is that — much like money in older quantity theory accounts — society has a limit on its demand for government debt. Since debt in advanced economies is mostly nominal, this pandemic surge led to a commensurate increase in the price level to bring real balances of government debt held to the public close to its initial level.

The view that demand for government debt is limited requires some explanation. At some level, government debt is just money we owe to ourselves, so it is not clear where the bounds lie. One possibility is that debt holding is bound by society's expectation that the government will indeed raise the requisite taxes to pay it back, even if it has a lot of flexibility in how and when it does it.

In particular, the government cannot let debt increase relative to GDP or national wealth ad infinitum. At some point, market participants will not want to hold more government debt, and the government will not be able to finance itself. Forward-looking participants would anticipate this outcome and immediately reduce their debt holdings. Under this view, inflation occurred because debt holders did not expect governments to ever raise enough taxes to cover their increased debt servicing needs.⁵

A related perspective requires less foresight by debt holders. It essentially recognizes that debt is money we owe to ourselves as a country, but this is not necessarily true at the individual level. Perhaps the taxes necessary to pay for the postpandemic debt surge will only be paid by yet unborn generations. In that case, transfers increase the net wealth of its recipients to be spent over their lifetimes. More generally, debt-funded transfers may relax liquidity constraints, allowing individuals who have little liquid savings or borrowing capacity to anticipate spending that they would otherwise have to put off.⁶

Under many (if not all) of those interpretations, one should expect inflation to remain high until the national debt reaches a lower, sustainable level. Indeed, the debt/GDP ratio in the U.S. has now receded to 120 percent after peaking at 130 percent in the first quarter of 2021. Of course, while this is consistent with theory, it is also consistent with other forces being at play.

Taking the government debt perspective, inflation is a phenomenon over which central banks have limited power. In fact, trying to fight it by increasing interest rates could even backfire, as it would lead to faster increases in debt. The solution to inflation under this perspective is to ensure that the government does not have large deficits or that it commits to raising the necessary taxes to keep debt sustainable without the need for inflation bouts. Again, while such commitments may help stabilize prices, whether they are good policy is unclear. Government spending greatly ameliorated the economic impact of the pandemic — especially among the most vulnerable population — and if inflation is costly, so are tax increases and cuts in government programs.

Summary

Is inflation caused by firms raising their prices, central banks enacting policy or government debt surging? At some level, the answer is possibly all of the above. Economic data will hardly allow for distinguishing among those views. Relative price changes between firms with more or less market power may not translate into higher price levels. And if monetary authorities had not acted, unemployment rates may have fallen way below their natural levels — leading to runaway inflation — and the debt-reducing effect of surging inflation would have taken place irrespective of the role of the fiscal authority.

Conversely, inflation could have been stopped through changes in any of those actions. There would be no inflation if firms were prohibited from raising their prices, though this may result in rationing, long shopping lines and the disappearance of many products from shelves. Also, central banks could commit to raising interest rates strongly in the face of any inflationary pressure, though this may lead to unemployment and spiraling government debt. Finally, the fiscal authority could commit to keeping debt low or at least sustainable. However, this may imply not helping people in need during an extraordinary time or imposing costly taxes that may lead to disincentives to economic activity.

The inflation surge of the last few years is, therefore, best seen as the outcome of various compromises and trade-offs done by the various parties. Firms needed higher prices to cover their increased costs, central banks were hesitant to hinder an economy already going through a highly uncertain patch, and governments wanted to help their citizens while avoiding costly austerity. At the same, some of the inflation may also have reflected abuse of market power by firms or miscalculations by central banks and governments.

One thing that polls and election outcomes have indicated is that citizens viewed the inflation surge highly negatively, indicating that more decisive measures may be welcomed to keep inflation in check in the future. In hindsight, a mix of more austere fiscal policy and/or tighter monetary policy may have been better received. As policymakers consider those, however, they may want to keep in mind the relative costs of their favored approaches.

Felipe Schwartzman is a senior economist in the Research Department at the Federal Reserve Bank of Richmond.

To cite this Economic Brief, please use the following format: Schwartzman, Felipe. (May 2025) "The Rabbit-Duck Question: What Cause the Recent Inflation Surge?" Federal Reserve Bank of Richmond Economic Brief, No. 25-20.

This article may be photocopied or reprinted in its entirety. Please credit the author, source, and the Federal Reserve Bank of Richmond and include the italicized statement below.

Views expressed in this article are those of the author and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.