At the beginning of this year, many economists took a bleak view of the prospects for falling inflation without a major economic slowdown and a major rise in unemployment. One prominent economist declared that underlying inflation was at least 4.5% and that “all the expected saviors” – that is, forces that could reduce inflation without suffering – “have come and gone.” Inflation, declared another, would be “sticky, around 4% to 5%.”
Given these expectations, what actually happened amounts to a small miracle, or perhaps not so small. Growth, both in GDP (Gross Domestic Product) and employment, remained solid. But standard measures of underlying inflation are now below 3% and falling. More sophisticated statistical models maintained by the New York Fed tell the same story and say that underlying inflation has halved since its peak last year.
Now, there may be some bumps in the coming months, mainly involving technical issues. Government statisticians have no problem estimating, for example, the price of eggs; Although they do the best they can, the methods they use to estimate the prices of services, such as healthcare, can sometimes produce implausible results that add noise to the data. No, the cost of health insurance has not dropped by 30% in the last year. And in the face of noisy data, there could be some bad inflation numbers in our future.
However, the drastic drop in underlying inflation this year is clearly real and corroborated by many sources, including business surveys. Voters, especially Republicans, may believe or say they believe that inflation is still rising, but while this belief may be politically important it is simply wrong.
Therefore, the big economic question of the moment is: what went right? How did Goldilocks arrive in the US economy?
As an important new paper by the Roosevelt Institute’s Mike Konczal highlights, there are two main stories that may explain why US inflation fell so quickly and painlessly. In any case, these stories are not later rationalizations, cobbled together to make sense of facts that no one expected. On the contrary, many economists, myself included, were telling these stories even during the winter of our inflation discontent, arguing that the kind of soft landing — disinflation without recession — that we now seem to be experiencing was actually possible.
So score a point for the optimists. But for reasons I’ll explain in a minute, it matters which of these two optimistic stories was right.
One of the two optimistic stories has the unpleasant name of the “nonlinear Phillips curve.” To put this into something resembling English, in normal times there appears to be a negative relationship between unemployment and inflation, but it is quite weak, implying that the Federal Reserve’s strategy of cooling inflation by raising rates interest rate and, therefore, the reduction in general demand, would have to cause high unemployment to bring inflation back to an acceptable level. The claim, however, is that in an overheated economy, as we appeared to have last year, the relationship between unemployment and inflation becomes much stronger, so that the Fed might have to cause only a modest increase in unemployment to produce a large decline in inflation.
The other optimistic story has, I believe, a better name, although I would certainly say that since I think I coined it: long transient, a play on long Covid. This is the argument that at the start of 2023 inflation was still high due to persistent supply disruptions caused by the pandemic, but that inflation is now coming down because the economy is finally normalizing.
There could very well be truth to both ideas. But the nonlinear Phillips curve explains why inflation could fall with just a small increase in unemployment; It doesn’t quite explain what we actually saw, which is the drop in inflation without any increase in unemployment. (The small increase in August was probably just a statistical blip.)
Konczal tries to resolve the issue by comparing disinflation across different goods and services. He argues that if improving supply as the effects of the pandemic fade is the main story, we should see inflation falling most quickly for goods and services whose consumption has increased most because their availability has increased. And that is in fact what we see.
Why is this dispute between inflation optimists important? Due to concerns that inflation could reaccelerate if the economy remains strong.
After all, if we believe that inflation fell quickly due to cooling demand, we have to worry that if the economy heats up again, for example because the Fed stops rate hikes too soon, the inflation could recover quickly. This is much less of a concern if we are mainly seeing the effects of post-Covid normalization.
So what I see as growing evidence in favor of the long transient story is reassuring. That said, it is clear that political decision-makers must remain vigilant.
This discussion is probably not over. What should not be a problem, however, is the proposition that inflation has fallen much faster than pessimists predicted, with no visible costs.
Translated by Luiz Roberto M. Gonçalves
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