A Victory Lap for the Transitory Inflation Team

PISA – As the world was recovering from the pandemic, inflation shot up, owing to widespread disruptions to global supply chains and sudden changes in patterns of demand. While the demand shifts might have posed a challenge to price stability even in the best of times, the breakdown in supply chains made matters worse. The market could not respond immediately to the new demand patterns, so prices increased.

Recall that we initially experienced a car shortage, simply because there was a shortage of computer chips – a problem that took 18 months to correct. The issue was not that we had forgotten how to produce cars, or lacked trained workers and factories. We were just missing a key component. Once it was supplied, automobile inventories expanded, and prices came down – disinflation set in. (Disinflation is a decline in the rate of inflation, not necessarily of the actual price level, and is what matters for central banks monitoring changes in prices. In this and several other cases, prices actually came down.)

Housing provides another example of this temporary, self-correcting phenomenon. Since population size is a major determinant of demand, the loss of one million Americans under Donald Trump’s pandemic mismanagement ought to have lowered housing prices at the aggregate level. But the pandemic also induced people to look for greener pastures. Major cities like New York came to seem less attractive than places like Southampton and the Hudson Valley.

Increasing the supply of housing in such places is not easy in the short term, so prices duly rose. But owing to well-known asymmetries in how prices adjust to changing market conditions, they did not fall commensurately in the cities. As a result, housing-price indices (which capture the average) went up. Now, as the effects of the pandemic have waned, prices (as measured by these indices) have drifted down slowly, reflecting the fact that most leases last for at least a year.

What role did the US Federal Reserve play in all this? Given that its interest-rate hikes did not help resolve the chip shortages, it cannot take any credit for the disinflation in car prices. Worse, the rate hikes probably slowed the disinflation in housing prices. Not only do significantly higher rates inhibit construction; they also make mortgages more expensive, thus forcing more people to rent instead of buy. And if there are more people in the market for rentals, rental prices – a core component in the consumer price index – will increase.

The pandemic-induced inflation was exacerbated further by Russia’s invasion of Ukraine, which caused a spike in energy and food prices. But, again, it was clear that prices could not continue to rise at such a rate, and many of us predicted that there would be disinflation – or even deflation (a decline in prices) in the case of oil.

We were right. Inflation has indeed fallen dramatically in the United States and Europe. Even if it has not reached central bankers’ 2% target, it is lower than most expected (3.7% in the US, 2.9% in the eurozone, 3% in Germany, and 3.5% in Spain). Moreover, one must remember that the 2% target was pulled out of thin air. There is no evidence that countries with 2% inflation do better than those with 3% inflation; what matters is that inflation is under control. That is clearly the case today.

Of course, central bankers will pat themselves on the back. But they had little role in the recent disinflation. Raising interest rates did not address the problem we faced: supply-side and demand-shift inflation. If anything, disinflation has happened despite central banks’ actions, not because of them.

Markets largely understood this all along. That is why inflationary expectations remained tame. While some central-bank economists claim that this was due to their own forceful response, the data tell a different story. Inflation expectations were muted from early on, because markets understood that the supply-side disruptions were temporary. Only after central bankers repeated over and over their fears that inflation and inflationary expectations were setting in, and that this would necessitate a long slog entailing high interest rates and unemployment, did inflationary expectations rise. (But, even then, they barely budged, reaching 2.67% for the average of the next five years in April 2021, before falling back to 2.3% a year later back).

Before the latest conflict in the Middle East – which again raises the specter of higher oil prices – it was clear that a “victory” over inflation had been achieved without the large increase in unemployment that inflation hawks insisted would be necessary. Once again, the standard macroeconomic relationship between inflation and unemployment – expressed in the Phillips curve – was not borne out.

That “theory” has been an unreliable guide over much of the past quarter-century, and so it was again this time. Macroeconomic modeling may work well when relative prices are constant and major changes in the economy revolve around aggregate demand, but not when there are large sectoral changes and concomitant changes in relative prices.

When the post-pandemic inflation started more than two years ago, economists quickly divided into two camps: those who blamed excessive aggregate demand, which they attributed to large recovery packages; and those who argued that the disturbances were transitory and self-correcting. At the time, it was unclear how the pandemic would unfold. Confronted with a novel economic shock, no one could confidently predict just how long it would take for disinflationary forces to appear. Similarly, few anticipated markets’ lack of resilience, or how much temporary monopoly power supply-side disruptions would confer on select firms.

But over the ensuing two years, careful studies of the timing of price increases and the magnitude of aggregate-demand shifts relative to aggregate supply largely discredited the inflation hawks’ aggregate demand “story.” It simply did not account for what had happened. Whatever credibility that story had left, it has now been further eroded by disinflation.

Fortunately for the economy, team transitory was right. Let us hope the economics profession absorbs the right lessons.