The Brookings Papers on Economic Activity, a conference held twice a year, is America’s premier forum for relating academic research to “the most urgent economic challenges of the day.” The lead presentation at the September 2022 conference was a paper by Laurence Ball, Daniel Leigh and Prachi Mishra on inflation. And its conclusions were dismal. Harvard’s Jason Furman, one of the assigned discussants, wrote an opinion piece calling it “the scariest economics paper of 2022,” suggesting that to get inflation down to 2 percent “we may need to tolerate unemployment of 6.5 percent for two years.”
Well, from where we’re sitting a little over a year later, things (thankfully) look quite a bit different.
I don’t mention this to beat up on the authors, all of whom have done past work I greatly respect and are very much part of the profession’s mainstream; Furman in particular has a reputation for being extremely careful. And if you read the minutes from the discussion at Brookings, there wasn’t a great deal of dissent.
My question instead is why so many economists got the inflation outlook so wrong. Unemployment is still near a 50-year low, yet here’s what happened to the Federal Reserve’s preferred measure of underlying inflation, the personal consumption expenditures deflator excluding food and energy (try saying that five times fast):
Before discussing what went wrong with those predictions, let me deal with two complaints I often get when I talk about disinflation.
The first is: what disinflation? Prices are still a lot higher than they were three years ago.
But when economists talk about inflation, they mean the rate at which prices are increasing, not their absolute level.
And trying to get the overall level of prices back to what it was before an inflationary shock, as opposed to stabilizing them, is almost always a bad idea. Winston Churchill, Britain’s chancellor of the Exchequer (basically their Treasury secretary) in the 1920s, tried that after World War I; the result was that while America was experiencing the Roaring Twenties, Britain went through a lost decade of high unemployment:
The second complaint I constantly hear involves assertions that the supposed fall in inflation is fake, because economists exclude the prices of the things real people actually buy. But this is almost exactly wrong. The U.S. Consumer Price Index contains a lot of stuff people do not, in fact, actually buy. As we’ve discussed before in this newsletter, a quarter of the index is “owners’ equivalent rent,” an estimate of what homeowners would be paying if they were renting their houses. If you want a measure that’s closer to how people currently spend their money, you want the Harmonized Index of Consumer Prices. Here are three measures of inflation over the past year, including that one:
“Core” inflation is actually the highest, because owners’ equivalent rent, for technical reasons, tends to lag far behind actual market rents — which rose a lot last year but have leveled off. One reason the Fed prefers that P.C.E. deflator we talked about above over the Consumer Price Index, by the way, is that it puts less weight on those questionable housing prices.
The bottom line is that disinflation is real — indeed, spectacular. Are we all the way back to 2 percent inflation? Probably not, although there’s a real angels-dancing-on-the-head-of-a-pin feel to the debate over the right measure of underlying inflation, and even over what that term really means. But we’ve gotten most of the way there, without a recession or even a large rise in unemployment.
So why were many economists so pessimistic last fall? I’d say that the failure to predict the disinflation of 2022-23 was a bigger intellectual pratfall than the failure to predict the inflation surge of 2021-22 — although I would say that, wouldn’t I, since I was among those who failed to see the initial inflation surge coming but conspicuously refused to join in the chorus of inflation doom.
Still, what strikes me about the dire inflation predictions of summer and fall 2022 is their non sequiturness (non sequituritality?). Back in 2021, those predicting inflation did so for a good reason: The Biden fiscal stimulus of early 2021 was very large, so it made sense to worry about excessive spending driving prices up. Predictions that inflation would remain stubbornly high, however, didn’t draw at all on the same logic; instead, pessimists came up with new, completely unrelated justifications for their pessimism.
One strand of argument involved parallels with the inflation of the 1970s, which was indeed very hard to get down. But the standard, textbook explanation of ’70s stagflation was that by the end of that decade, expectations of future inflation were deeply entrenched in the economy — which clearly wasn’t the case in 2022.
The other argument was that there was an unusually high number of unfilled job openings given the unemployment rate, which was supposed to imply that we needed much higher unemployment than in the past to keep inflation down. But it always seemed odd to assume that unusual job dynamics in an economy still very much disrupted by the lingering effects of Covid-19 represented a new normal, and economists at the Fed and elsewhere were quick to question the case against a soft landing.
Notice, by the way, that these arguments for persistent inflation weren’t just unrelated to the original case for inflation; they were also unrelated to each other — almost as if economists were looking for reasons to be pessimistic.
Anyway, I do think it’s time for quite a few economists to engage in some soul-searching. (Yes, even economists have souls. Some of them, anyway.) I’m not necessarily asking for mea culpas similar to those issued by some of us who got the first phase of this inflation cycle wrong, although it would be nice. Instead, I’d like to see some hard thinking about how so many of my colleagues got this story so wrong, and maybe even a bit of introspection about their motivations.
Supply-side expansion has driven disinflation.
Wage growth is near where the Fed needs it.
The economic consequences of Mr. Churchill (by John Maynard Keynes).
Facing the Music
An uplifting version of a CSN classic.
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