It was easy to miss in all the hubbub over the Presidential debate and Donald Trump chickening out of a rematch, but there was some significant economic news last week. The Labor Department announced that the rate of inflation fell to 2.5 per cent in August, the lowest level since February, 2021. After this positive development, Jerome Powell and his colleagues at the Federal Reserve are set to cut interest rates on Wednesday.
Assuming the rate reduction goes ahead, it will be the first one since March, 2020, when, amid the outbreak of the COVID-19 pandemic, the Fed tried to cushion the economy by slashing the federal-funds rate all the way to zero. Two years later, the central bank reversed course to head off rising inflation. It ended up hiking rates no fewer than eleven times. On Wall Street, analysts are busy debating whether this week’s cut will be a quarter point or half a point, but that’s a bit like squabbling about whether Aaron Judge will hit the next pitch over the left-field fence or the right-field fence at Yankee Stadium. The important thing is that the rate cut is almost certain to be the first of a series, which would bring down the cost of mortgages and consumer loans and give a significant boost to the economy. (Conceivably, it could also pump up incipient bubbles in the markets for stocks and real estate, but that’s a story for another column.)
The Fed’s move will be a coda to the pandemic era of policymaking, but it won’t end the debate about how inflation turned into such a problem to begin with, or, despite what Trump and the rest of the G.O.P. would have you believe, why it has receded. Some commentators are giving credit to the Fed, and central banks in other countries, for taking such forceful action—all those rate hikes—to anchor inflation expectations. But that may be merely a rationalization. “The reality, of course, is that the central bankers got lucky and are now taking credit for developments that were either beyond their control, or would have happened anyway,” Dario Perkins, an economist at TS Lombard, an international financial research firm, wrote earlier this summer.
During the past few years, inflation has fooled virtually everybody at some point. In 2021, many policymakers and observers (this one included) adjudged rising prices to be a transitory phenomenon and urged a cautious response to them. “The good ship Transitory was a crowded one, with most mainstream analysts and advanced-economy central bankers on board,” Powell recalled in a recent speech at a Fed conference in Jackson Hole, Wyoming. The continued upward march of inflation embarrassed the members of Team Transitory, and, in November, 2021, Powell said the term should be dropped. (Inflation peaked the following summer at 9.1 per cent.)
Score one for the inflation hawks, who had warned that monetary and fiscal policies were too lax. But subsequent developments made a mockery of their claims about how costly bringing inflation under control would be. In June, 2022, Harvard’s Lawrence Summers said it would require five years of unemployment above five per cent. During the next twelve months, the jobless rate barely budged, but the inflation rate fell by two-thirds, to three per cent.
How did both sides get it wrong? Part of the problem was reliance on oversimplified textbook models, such as the Phillips curve, which posits that there is a straightforward relationship between inflation and unemployment. Misreading history was another issue. A long period of low inflation and low unemployment before the pandemic led policymakers to underestimate the possibility of inflation surging. After it started to do so, hawks invoked the experience of the nineteen-seventies, when prices and wages chased each other upward, and the inflation rate rose to more than ten per cent. Some of them brought up Arthur Burns, the Fed chairman from 1970 to 1978, who is widely blamed for failing to respond aggressively enough to the inflation threat.
But the comparison with the seventies was off base. After four decades of globalization, the U.S. economy is less prone to inflation spirals than it was back then. It’s more open to foreign competition, and labor unions are much weaker, meaning workers are less able to demand “catch-up” wage increases after prices rise. “Inflation is not just about money,” Perkins notes. “It is about power. Workers today were never going to have enough power to generate a persistent wage spiral.”
In 2021-22, the initial burst of rising prices was largely driven by pandemic-related closures and problems in the international supply chain, which generated shortages of many products at a time when there was a lot of pent-up demand. The start of the war in Ukraine added another inflationary twist by causing energy prices to skyrocket. In the spring of 2022, the cost of gasoline rose to above five dollars a gallon in many parts of the country.
Workers did see higher wage increases, but wage inflation didn’t catch up with price inflation until last year, when the rate of price inflation was already falling back. Moreover, studies showed that many of the price increases during the inflation spike could be attributed to corporations taking the opportunity of strong demand and limited supply to pad their profit margins. That looked more like a profit-price spiral than a wage-price spiral.
Early in the current inflation debate, at least one highly placed group of economists did draw a more appropriate lesson from history. In a July, 2021, blog post, Cecilia Rouse, the chair of the Council of Economic Advisers, and two colleagues—Jeffery Zhang and Ernie Tedeschi—highlighted the years immediately after the Second World War, when the U.S. inflation rate jumped to more than fourteen per cent in 1947 before falling back to minus one per cent by the end of 1949. In the course of the war, a lot of factories had been reoriented to produce armaments, which meant consumer goods were in short supply. After the fighting ended, households that were eager to get back to normal bought a lot of the goods and services they had been deprived of, and prices shot up. (Another factor: wartime price controls had been lifted.) “Today’s shortage of durable goods is similar,” the White House economists wrote. “A national crisis necessitated disrupting normal production processes.” They noted that the postwar inflationary period “ended after two years as domestic and foreign supply chains normalized and consumer demand began to level off.”
Something very similar seems to have happened today. The costs of transporting goods in shipping containers from China peaked in early 2022, then fell by about four-fifths in the next twelve months. Over the past couple of years, conditions in U.S. labor markets have also normalized, with many people who dropped out of the workforce during the pandemic getting back on the job and the number of vacancies steadily dropping. Wage increases started to moderate even before inflation reached its peak. In March of 2022, the hourly earnings of American non-farm employees were rising at a rate of 5.9 per cent on a year-over-year basis, according to the Economic Policy Institute, a Washington think tank. By this summer, the rate of wage increases had fallen below four per cent.
