Economically, 2023 will go down in the record books as one of the best years in history: a year in which inflation fell at a staggeringly fast pace and with no visible costs, defying many economists' predictions that disinflation would require years of high unemployment.
At least so far, public opinion does not seem willing to believe the good news or give any credit to the Biden Government. But this column is not about the apparent gap between voters' perceptions and reality, but rather about some influential economists and officials unwilling to accept the fact that they were wrong.
Why should we care? The point is not to score personal points, although I am a strong advocate that one should acknowledge past mistakes, because that is how one learns, and it is also good for the soul. What worries me is that if we cling to a view of the economy that has been refuted by recent events we are more likely to screw up and subject the economy to a recession that it now turns out we did not need, nor do we need, to control the economy. inflation.
To what extent has the performance of the economy been spectacular? In March, the Federal Reserve committee that sets monetary policy was still predicting that we would end this year with an unemployment rate of 4.5% and with the Fed's favorite indicator, “core” inflation, at 3. 6%. Last week, the same group predicted unemployment of only 3.8% and core inflation of only 3.2% by the end of the year. But in fact, the news is even better, because that last figure is inflation for the year as a whole; Through the six months ending in October, core inflation was 2.5%, and most analysts I follow believe that when the November data arrives later this week, it will show inflation at around 2%, which is the long-term objective of the Federal Reserve. Soft landing achieved.
How have we been able to do it? The answer seems pretty clear. Economists who argued that the spike in inflation in 2021-22 was “transitory,” driven by disruptions caused by the Covid pandemic and the Russian invasion of Ukraine, were apparently right, but those disruptions were larger. and longer-lasting than almost anyone imagined, so “transitory” ended up meaning years instead of months. What has happened in 2023 is that the economy has finally resolved its post-pandemic problems, such as supply chain disruptions and the mismatch between job offers and unemployed workers.
This is not a casual guess. Rising employment coupled with falling inflation is exactly what would be expected in an economy with improved supply chains. It's also what we see when we look closely at the economy: the fastest-growing sectors have seen the sharpest declines in inflation. And statistical inflation models that include supply chain indicators follow the evolution of inflation in recent years more closely than more conventional models.
But many of the economists who were overly pessimistic about inflation – especially Larry Summers, although he is not the only one – remain reluctant to accept the obvious. On the contrary, they maintain that the credit for disinflation must be attributed to the Reserve, which began to raise interest rates drastically in 2022.
The question is how that is supposed to have worked. The original pessimistic argument was that the Fed needed to create a lot of unemployment to reduce inflation. As far as I know, the current argument is that by acting tough, the Fed convinced people that inflation would go down, and that this was a self-fulfilling prophecy.
To my knowledge, there is absolutely nothing to prove this claim. Although financial markets pay close attention to the statements of the Federal Reserve, producers and workers, who set prices and wages, do not; They base their decisions on what they see around them.
Here we perceive some historical echoes. About a decade ago, some economists and policymakers insisted that cutting public spending would increase employment by encouraging greater investment; I mocked this view, which turned out to be totally erroneous, referring to it as faith in the Trust Fairy. What we are seeing now could be called faith in the Credibility Fairy.
Let it be clear that I do not blame the Federal Reserve for raising rates earlier. Last year we didn't know the inflation story would end so well, and to be fair, rate hikes haven't actually caused a recession, at least so far.
What worries me is the future. In general, the same people who were wrong in their pessimism about disinflation are now warning the Federal Reserve not to lower interest rates quickly. Because? Well, if you believe that any rise in inflation will be very difficult to reverse, and you also believe that the Fed's perceived firmness was crucial in bringing inflation down, I suppose you'd be willing to take big recession risks for preserve the credibility of the Reserve when it comes to fighting inflation. But neither belief is supported by evidence.
Has the war against inflation been definitively won? No. But recession seems a bigger risk than a spike in inflation. And I worry that this risk will increase if policymakers listen to people who refuse to admit they were wrong about inflation and cling to a false theory about how we got it down.
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