Inflation is down, but it's not clear why
The news regarding the economy has been very good over the last few weeks. Employers added nearly 190,000 jobs last month and the unemployment rate went down to 3.5%. Inflation has come down from a peak of roughly 9% a year go to roughly 3% now. GDP during the second quarter of this year grew at a rate of 2.4%, higher than expected. Consumer spending is still strong and consumer sentiment has started moving upward.
Conventional wisdom has shifted markedly in favor of the belief that inflation will be brought down without causing a recession. JP Morgan, for example, has now revised its forecast through 2024 to no longer include a recession. Economists surveyed by the Wall Street Journal have revised downward their predictions of a recession.[i]
It wasn’t long ago when it was believed by almost everyone that a big rise in unemployment was imminent.[ii] I discussed in my last piece on the economy why that has so far turned out to be wrong. In this piece, I want to discuss why inflation has come down just as fast as it went up. As far as I can tell, there is no solid consensus among economists and others about why that has happened.
Supply, demand or both?
I am hard pressed to think the answer isn’t both, but I have no idea what percentage of it each makes up. The first big debate about inflation when it started to show up was whether it was transitory or persistent. I briefly mentioned that in my last piece on the economy and am not going to repeat it here. After it became clear that inflation was going to stick around, the debate became about whether it was mostly caused by supply or demand factors.
For consumers, the cause of inflation doesn’t really matter. They are stuck paying higher prices no matter what. For policymakers, the cause is very important. The Fed is in charge of raising interest rates, which is how it brought down inflation in the 1980s. That caused what was the biggest economic downturn since the 1930s. Almost everyone today agrees that move was necessary, but it was a bad situation that we shouldn’t want to find ourselves in again.
While raising interest rates can have a big impact on the economy, it can only do so by affecting demand. If inflation is caused by demand being too high, then making borrowing more expensive is going to be necessary. That will reduce demand, which will reduce prices. However, if inflation is caused by insufficient supply, then raising interest rates is not going to help. The solution will have to come from supply being increased. That is much harder to do because there isn’t one neat trick that policymakers can use to make it happen.
The inflation of the 1970s and 1980s was mostly a demand problem, which is why raising interest rates worked. The inflation of today is mostly supply or mostly demand depending on who you ask. Just don’t ask me because your guess is as good as mine.
Those who wanted the Fed to err on the side of lowering unemployment favored the supply explanation. In their reasoning, the more important issue was to make sure employment kept going up and that we didn’t have another lousy recovery with years of high unemployment. Millions of people had left the workforce during the pandemic and it was important that they return to it. If the Fed raised interest rates, that would reduce demand, which could mean reducing hiring and raising unemployment.
Why would they favor the supply explanation for inflation? Because the raising of interest rates would not bring it down. To give a small example, say there is bike factory that manufactures half the bikes in the world. If something happens that shuts down the factory, that is going to dramatically reduce the supply of bikes. Demand will not change and so prices will surge. If lenders to the bike manufacturer decide to charge it more to borrow, that wouldn’t help to produce more bikes and could make it harder. The solution is to get the factory running again so more bikes can be produced and demand can catch up to supply.
Advocates of the supply side explanation were making an argument like that, just on a global scale. There is truth to that explanation. The pandemic shut down manufacturing facilities all over the world, which reduced production. It also sent a lot of people out of the workforce for some time. It’s important to remember that supply isn’t just of physical goods, but includes workers, too.
If companies can’t hire enough workers, they can’t produce enough of what they make. Similarly, service businesses can’t provide as many services or serve as many customers if they don’t have enough workers. With demand being the same, the price of services will go up. Inflation is often associated with goods, but services are affected, too. In fact, the biggest source of inflation now is in services and not goods.
Many workers remained on the sidelines for a whole host of reasons. Only recently has that begun to change, which will be helpful for reducing inflation and avoiding a recession. Contrary to what many economists and others believed, the number of workers has not been permanently reduced. In the last year, more than 3 million people have joined the workforce. The prime age workforce participation rate (ages 25-54) is now higher than it was pre-pandemic. Many labor market myths have been shattered over the last year and that was one of them.
Supply problems were not just caused by the pandemic, but by other external events, too. Most notably, Putin’s invasion of Ukraine initially caused a surge in gas prices. It has also caused a shortage in grains that feed a good chunk of the world.
Supply, however, is just half of the equation. Demand is a big factor, too, and, depending on who you ask, even bigger. Those who emphasized demand being the cause of the inflation surge, unsurprisingly, favored the Fed erring on the side of reducing inflation. The argument was that if inflation is allowed to fester, it will take on a life of its own. Once that happens, it becomes self-fulfilling. For example, if people begin to expect higher prices they will demand higher wages, which will lead to higher prices.
That is arguably what happened in the 1970s. Inflation was neglected for years and eventually went into double digits. The problem was demand was too high. By holding off on raising interest rates until 2022, the argument went, the Fed was allowing inflation to persist and grow, just like in the 1970s. The more the Fed waited to raise interest rates, the worse inflation would get and the higher and faster interest rates would have to be raised.
Advocates of focusing on reducing inflation tended to blame both Congress and the Fed for its rise. In their telling, the stimulus measures passed by Congress were excessive, especially the stimulus passed in March 2021. Too much money was pumped into the economy and that raised demand to a level that the existing supply couldn’t accommodate.
It is possible for Congress to take actions that reduce demand. For example, Congress could impose a consumption tax on goods and services. It could also raise income taxes on everyone and/or cut spending. Those steps would reduce inflation by reducing demand, but the politics of it are toxic. While Congress can technically do things to reduce inflation, it has never really happened before and was never on the cards this time around.
When it comes to reducing inflation via reducing demand, the Fed really is the only game in town. Those who argued in favor of raising rates sooner almost always argued that unemployment would have to go up. Historically, that is how it has been even though the sample size is very small. According to that argument, raising unemployment is bad, but is necessary to get inflation back down so as to avoid it getting worse and necessitating an even bigger downturn in the future.
The Fed began raising interest rates in March 2022 and inflation peaked in July of that year. Intuitively, it certainly seems that raising interest rates has had an effect on lowering inflation. However, there are some who know way more about economics than I do who argue it has had only a small impact. Certainly the fixing of various supply chain issues around the world has had an effect. Looking back at the problems in 2021 and 2022, it’s amazing how well the US economy has done.
After Russia invaded Ukraine, gas prices surged, peaking at nearly $5 a gallon. Since then, prices have come down. The problems plaguing factories around the world have largely passed and manufacturing of all types has increased. In the case of workers, there were millions of them sitting on the sidelines, but that number has been coming down.
Surviving all those supply shocks is impressive enough. Making it even more amazing is that interest rates have gone from 0% to nearly 5.5% in less than 18 months. Despite that, unemployment is basically the same as it was in March 2022. Hiring has slowed from its peak months, but it is still strong. The sector that is most affected by the increase in interest rates, construction, is still adding jobs.
So far the damage caused by the rise in interest rates has been very limited. The most notable casualty was Silicon Valley Bank. The tech sector has also seen a slowdown, but, contrary to what some seem to think, there is no white collar recession happening right now. Those who lost their jobs in the tech sector have tended to find jobs in other sectors fairly quickly.
The effectiveness of the Fed
There is an argument to be made that the Fed really isn’t that powerful, at least not anymore. Last decade, the Fed tried several rounds of quantitative easing (QE). The goal was to raise demand, which was sorely lacking. Despite those efforts, unemployment remained high. Having read multiple books discussing the subject, I still have no idea whether the QE experiment was good. I don’t think I ever will.
It’s true that unemployment remained high during those years, but we have no way of knowing what the counterfactual would have been. Maybe without QE, the economy would have been even worse off. QE was certainly controversial and attracted a lot of criticism. Some of that was likely legitimate although much of it was wrong and I’m not even counting the conspiracy theories. For example, one of the criticisms of QE was that it would cause a surge in inflation. Whatever its flaws, QE did not do that.
That mistaken criticism shouldn’t be forgotten. Fears of runaway inflation were hyped a lot during the 2010s when unemployment was high and inflation was consistently below the Fed’s 2% target. The fear of a surge in inflation never came to pass. Worrying about inflation then was the wrong focus and diminished the credibility of those who pushed for it. Anyone who predicted QE would cause inflation to surge and is now claiming vindication because of the post-pandemic surge should never be listened to again on that subject.
The merits of QE aside, monetary policy is limited in what it can do. The potential of monetary policy to bring down inflation is well established, but its ability to stimulate employment growth is not. That is why fiscal policy is needed. The Fed took critical actions in 2020 to help avoid another financial crisis. However, the most important aid was provided by Congress, which helped to keep demand from collapsing. By doing that, Congress turned what could have been a major depression into a very mild recession that ended quickly. Economic downturns may not be preventable, but slow recoveries are.
Although the Fed has the ability to raise or lower interest rates and to take other actions during extraordinary circumstances, that is not necessarily all it can do. There is an argument from some economists and others that what the Fed can be most effective at is influencing expectations. For example, by convincing people that it will do whatever it takes to reduce inflation, people plan accordingly. The Fed has arguably done that over the last year.
By credibly convincing people that it is determined to bring down inflation, it has done so without tanking the economy. I briefly mentioned that possibility in a piece I wrote last year. The idea is that since people believe inflation will come down in the future, they won’t do things that will make it worse today. By not expecting higher prices in the future, people won’t spend more money now. In doing so over the last year, people reduced consumption, which reduced demand, but didn’t reduce it so much that it caused a recession.
What was so unusual about the predictions of a recession that were prevalent until just now is that they were being made at all. There have been plenty of recessions before, but I’m not aware of one that everyone saw coming. When recessions happen, it has almost always been when people were ecstatic and enjoying boom times. Economic prosperity has a tendency to make people forget about previous bad times and assume the good times will last forever. That belief can wind up leading to a downturn once irrational expectations meet reality. What is happening now may be the reverse of that.
One writer compared this phenomenon to getting a flu shot. It might make you feel lousy for a bit, but it keeps you from getting the real thing or makes it much more mild. The goal was to avoid getting the flu (a recession). To do that, people needed to feel a little lousy (reducing spending).
I have no idea whether that’s right, but I really want it to be. If it’s right it would mean the Fed doesn’t just do monetary policy, but is a macroeconomic vibes manager, too. In other words, by making everyone think a downturn was going to happen, the Fed convinced people to prepare for it, which wound up preventing it.
The reason I want it to be right is because if the Fed can do it now, it can potentially do it again the next time there is inflation and avoid a recession. It may even be possible that the Fed can convince people that things are going to be good so as to get them to spend more the next time that is needed. We should all hope we never again have a situation like we did in the 2010s where demand needed to be boosted, but Congress refused to do it. Unfortunately, we might and if we do it would be great if the Fed could successfully boost demand in the absence of a willing Congress. A solution from Congress would be preferable, but you work with what you have.
[i] All of these predictions/forecasts should be taken with a grain of salt. They are just educated guesses at best. I’m somewhat seriously beginning to worry that this newfound euphoria makes a recession more likely. That’s not scientific, but conventional wisdom has been wrong about so many things since 2020 and there is no reason to automatically believe it’s right this time, as much as I hope it is.
[ii] A model created by Bloomberg predicted in October 2022 that there was a 100% chance of a recession occurring within a year. Barring something cataclysmic, that won’t be happening. Pro tip, if your model gives something as unpredictable as a recession a 100% or 0% chance of happening, it’s a bad model and should be thrown out.