Everyone can be happy about the recently reported decline in the US inflation rate, but how and why did it fall so quickly without causing a recession on the way down? Among the plausible hypotheses, there seems to be a clear winner — the transition was conducted with a high degree of credibility from the Federal Reserve and the government.
One hypothesis is that inflation came down quickly because of the unwinding of Covid supply chain problems and adjustment to the Ukraine war. In this view, prices were much higher at first because supply was stifled. But as markets adjusted and learned how to work around the new obstacles, supply found new channels, more goods came on the market, and prices stopped rising or falling. Nothing in that story suggests that a recession ought to take place.
That mechanism is certainly part of the narrative, but it is difficult to believe it explains most of it. After all, once inflation got underway, it spread broadly throughout economic categories, including services. The supply chain narrative would seem to apply best to discrete physical goods such as food and energy.
Furthermore, the money supply (M2) rose by about 40% from February 2020 to February 2022. Surely that had something to do with the inflation in prices. M2 growth turned negative in 2022, and that very likely has something to do with the drop in inflation.
The Fed and Chair Jerome Powell deserves considerable credit for increasing interest rates, offering forward guidance on disinflation, and allowing M2 to shrink. But that only explains in part why inflation has fallen to 3%. Many economists predicted that such a transition would cause a recession because less spending lowers the demand for goods and services, which can lead to layoffs and less optimistic business plans.
Enter the notion of “credibility.” A long-standing tradition in macroeconomics, sometimes called rational expectations, suggests that a truly credible central bank can lower inflation rates without a recession. If the central bank announces a lower inflation target, and most people believe the central bank, wages, and prices adjust in rough sync with demand. All nominal variables move upward at a slower pace, markets continue to clear, and the economy keeps chugging along. Because individuals in markets believe the disinflation process is real, they are willing to act in accordance with it in their pricing and wage-demand decisions.
Although rational expectations theory has undergirded several Nobel Prizes (see Robert E. Lucas and Thomas Sargent, for example), most mainstream economists these days do not believe in it as a general approach. The critics might be behavioral economists who scorn the notion that individuals are rational in their market decisions, or they might believe that full credibility is rarely if ever present. After all, do we not live in an age of low trust and mixed-quality governance? Over the last year, for instance, I have been party to numerous conversations suggesting the Fed will be afraid to pursue disinflation out of fear of inducing a recession and indirectly electing Donald Trump as president.
And yet it seems the credibility has been there, and so we can give plaudits to various parts of the federal government, including President Biden, for supporting Powell and the Fed. At no point did the president intervene to bash the central bank or send a mixed message, and so the disinflation had implicit stamps of approval from majorities in both parties. It is often the job of Congress to complain, but there were no serious moves made against the independence of the Fed, even if Elizabeth Warren and a few others squawked.
As for the commentariat, a diverse array of economists ranging from the Keynesian Paul Krugman to many conservative economists recognized that rate increases and disinflation were necessary and had to be done with promptness and fortitude. And so credibility reigned.
Granted, the rational expectations view is not always correct — and a recession somewhere down the road isn’t out of the question — but at least in this instance America pulled together and did the job. This sequence of events, which is continuing, should serve as a lesson to those predicting either the decline of America or the creeping polarization and paralysis of our politics. The disinflation can serve as Exhibit A for American optimism and a demonstration that we are still capable of making our own future.
Unfortunately, many other countries, including those across the Atlantic, are still struggling with high inflation. Can it be that the European Central Bank and Bank of England do not have comparable consensus and national unities behind them? On this issue, we can praise the US for a job well done.
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