It’s the summer of 2022. Inflation is spiraling out of control, having recently reached 9.1% annually through June (Thanks, Biden). According to conventional wisdom, policymakers at the Federal Reserve had a grim choice: raise interest rates and send the US into a recession, or allow inflation to continue to rage across the American economy. Based on this calculus, the vast majority of economists predicted that a recession was inevitable. Former Treasury Secretary Larry Summers predicted that we would need five years of unemployment above 5%. One Bloomberg model forecasted the probability of a recession to be 100%.
Then, something unexpected happened. In a macroeconomic tidal wave that has often been called the ‘immaculate disinflation’, inflation has decreased over the last 1.5 years. Rapidly. Without a recession.
November’s data had inflation at 3.1%, far down from the peaks of 9% last summer and near the Fed’s goal of 2%. Meanwhile, unemployment has remained at 3.7%, its lowest point in decades, and US GDP grew at an annual rate of 4.9% in the third quarter of 2023 (although this number is likely artificially high due to short-lived increases in consumer spending).
While it is not guaranteed that inflation will settle back down to 2% without any hiccups, one thing is clear. At least thus far, inflation reduction has not required a recession, a fact that basically the entire field of economics missed a year and a half ago.
How did so many economists get inflation wrong, and how should we adjust our understanding of macroeconomics based on our little disinflationary miracle? To see what went wrong, it is worth looking at the traditionalist view of monetary policy. The traditionalist view holds that, to decrease inflation, it is generally necessary to induce a small-scale recession. This recession will slow the economy and squeeze consumers’ purse strings to such an extent that price levels decrease.
This theory’s Epic Hero is Paul Volcker, the Chairman of the Federal Reserve appointed in 1979, who is widely credited with ending the ‘stagflation’ that plagued the American economy throughout the 1970s. Volcker, using high interest rates as his sword, slayed the inflationary dragon by slowing output in the economy to such an extent that prices stopped rising.
Volcker’s attack was not without its costs. Raising the federal funds rate from 11.2% to 20% carpet-bombed the US economy. While inflation decreased from a high of 14.8% in March 1980 to below 3% in 1983, the aggressive monetary policy led directly to the 1980-82 recession, in which unemployment rose above 10%. Before Covid, this damage was widely believed to be a necessary evil for any policymaker facing rampant inflation.
Yet, in the last year or so, the US emerged largely unscathed from its battle with inflation. How could this be the case? One answer is that several Covid-related idiosyncrasies made the 2022-23 fight against inflation unique.
The summer 2022 peaks of inflation were driven to a significant extent by shocks to both supply and demand. The Russian invasion of Ukraine and ensuing Western sanctions dramatically reduced the supply and increased the prices of oil and grain, just as the global economy was clawing its way out of Covid-era supply-chain disruptions. At the same time, consumer savings were driven up by Covid-era stimulus from the American Rescue Plan and the (ironically named) Inflation Reduction Act, in turn increasing demand and driving inflation.
Over the last year or so, these shocks gradually stabilized: the West found alternative oil and gas sources, particularly in the form of liquified natural gas, supply chains broadly recovered, and consumer deposits have gradually (although certainly not entirely) depleted their pandemic-era surpluses. The upshot of all this is that the inflation and subsequent disinflation that we saw over the past couple of years may have been a unique cocktail brewed by global events.
It certainly is true that global events are a partial explanation of why a recession was not necessary. However, it would be overly hasty to jump to the conclusion that they are the only explanation, or even the most important one. The 1970s ‘great inflation’ that Volcker fought was also at first driven by real-world events, namely a shock to oil prices. However, it grew to outlive the artificial constraints on oil production. To explain what changed this time around, it is most important to look at one factor – expectations.
Inflation is almost always driven, at least to some extent, by expectations. The reason why is fairly simple – if I expect inflation will be high, I will raise my prices to recoup my losses. If workers expect inflation will be high, they will ask for higher wages via industrial action. This in turn raises prices further and can quickly become a self-fulfilling prophecy.
In the 1970s, the Fed failed to take significant steps to manage inflation expectations. Operating under a traditional Keynesian paradigm, many officials thought they could simply ‘let inflation be’ in order to prevent a recession. This almost certainly made the problem worse.
By contrast, in the Covid pandemic, officials were far more hawkish about inflation. Each member of the Federal Open Markets committee, the committee that manages the federal funds rate (the most important interest rate), spoke about how they will unrelentingly fight inflation. After some initial hesitancy, the Fed aggressively began raising interest rates. This led many agents in the economy to believe that the Fed, one way or another, would succeed in lowering inflation, in turn expunging their noxious inflation expectations. Inflation management thus costlessly accomplished a lot of the Fed’s work for it.
While it is difficult to quantify precisely how much of this work was accomplished via expectations, IMF projections suggest that, by this year, nearly all the continuing decreases in inflation rates have come about via expectation management. Similar studies by the IMF find that every 1-point decrease in inflation expectations in an advanced economy such as the US corresponds to a 0.8% decrease in inflation rates.
The enduring lesson of the pandemic in terms of monetary policy will probably be something to do with inflation expectations – namely that inflation expectations themselves can drive an economy out of an upwards price spiral. It is generally agreed now that expectation management is one of the most important tasks of any central bank. Controlling expectations may have been forged into a more potent tool. Since it is now widely accepted that inflation expectations can themselves be a solution, actors across the US may expect inflation to go down without the Fed ever actually damaging the economy.
Some take this line of reasoning one step further, and have argued that the pandemic shows that we should entirely eschew Volcker’s monetary policy. A recent Atlantic article called the Volcker theory ‘The 1970s Economic Theory That Needs to Die’.
However, to do so would be overly hasty. A central bank can only affect expectations insomuch as it is credibly believed. When price spirals cannot be ended via expectation management, a Volcker disinflation is a necessary, albeit costly, backstop. It is also interesting to note that even suggesting we should not pursue Volcker recessions may cause agents in the economy to think that the Fed will not be sufficiently hawkish against inflation, and therefore set their prices higher. Thus, even if one believes monetary policy should be primarily conducted via expectation management, actually saying this runs the risk of cutting the ground beneath one’s own feet.
More than its direct implications for our macroeconomic theories, I think there is one final lesson from the ‘immaculate disinflation.’ It goes something like this: economists, like most academics, tend to build their ideas around certain orthodoxies within their fields. In the 1970s, the orthodoxy was standard Keynesianism, which turned out to be insufficient to fight the inflationary threat, while before Covid the Volcker theory of disinflation was standard, which missed the overwhelming importance of expectation management. Right now, the view I am expressing – one that focuses on expectations – is morphing into a form of consensus. This is dangerous.
Academic groupthink, while certainly useful to a reasonable extent, can create blind spots. If a possibility is not represented in a model, people may wrongly think it cannot materialize. This is especially true because in economics we are always hampered by the imperfections of available data. The fact that we had never seen inflation ebb primarily due to expectations did not mean that it was impossible for it to do so. If nothing else, the lesson we should learn from the ‘immaculate disinflation’ is to keep an open mind about new possibilities that may not align with our current assumptions. Anything can seem like a miracle if we excessively restrict our theories.