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It’s 2021 again. We have rising Covid cases, poor prospects for British athletes at the Olympics, and a public fight about transitory inflation.
Back then, the argument made by “team transitory” economists (and Jay Powell, for a while) was that price pressures were mostly attributable to lockdowns, jams in supply chains and Russia’s war in Ukraine. But inflation picked up pace and prices rose in an increasing number of sectors, even as economies reopened. The Fed abandoned “transitory” and started raising interest rates. By the time CPI passed 9 per cent in 2022, the argument seemed dead.
But the dramatic drop in inflation in the last year, without a commensurate increase in unemployment, has revived the fight. Joseph Stiglitz, the Nobel-prize-winning economist, in November published “A Victory Lap for the Transitory Inflation Team”, which does what the headline promises. He says the “self-correcting” trajectory of car and house prices shows that inflation was transitory all along. The problem was one of supply — not enough cars, for example — rather than too much demand from consumers with more to spend thanks to post-Covid economic recovery programmes.
The implication is that the Fed’s enormous interest rate increases are not primarily responsible for the slowdown in inflation in 2023.
“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; but 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,” says Stiglitz.
The stakes of this argument are higher than in an ordinary spat among macroeconomists. If the Fed’s hikes were not responsible for bringing down inflation, the bank can cut interest rates whenever it likes without threatening an acceleration.
That’s the view of Ajay Rajadhyaksha, FT Alphaville contributor and global chair of research at Barclays:
It is not clear to me that it was rate hikes that ultimately brought inflation down. Very thoughtful economists said that unemployment had to rise dramatically to bring inflation down — and it hasn’t. We are back down to near 2 per cent inflation, but the labour market hasn’t slowed. There’s an argument that “team transitory” was right all along — though it took longer than expected,
The continued strength of the labour market is the key point here. Economists including Larry Summers, Jason Furman and Laurence Ball argued that unemployment was going to have to rise dramatically for the Fed to bring inflation down. These arguments are rooted in the concept of the Phillips curve, which maintains that unemployment and inflation have an inverse relationship.
The Fed’s preferred gauge of inflation — the core personal consumption expenditures index — today stands at 3.2 per cent, having fallen from a peak of 5.6 per cent in early 2022. Over that same period, unemployment has been virtually flat, moving from 3.8 per cent in February 2022 to 3.7 per cent today.
Without mass lay-offs, it’s harder to argue that inflation was a demand-side problem, one in which Americans had too much cash on hand. Inflation has come down despite the fact that unemployment remains low and wage growth has been strong. The changes in demand haven’t been big enough to explain the change in inflation.
Claudia Sahm, former Fed economist and originator of the “Sahm rule” recession indicator, has been a member of “team transitory” from the start. The steady rate of US unemployment proves inflation was a supply, not demand, issue, she says.
“If this was all about demand, we would be in trouble. We would be in a situation more like the 1970s. The fact we had inflation come down so much, and unemployment not rise too much, meant we didn’t need a recession to get inflation down. If inflation had been driven by demand, we would have needed a recession to get inflation down,” said Sahm.
The Fed does not yet seem convinced by these arguments. Governor Christopher Waller last week said “Well, if these are temporary supply shocks, when they unwind, the price level should go back to where it was. It’s not. Go to Fred. Pull up CPI. Take the log. Look at that thing. The [price level] is permanently higher. That doesn’t happen with supply shocks. That comes from demand. And this was a permanent increase in demand and permanent increase in debt.”
That’s not exactly true. Inflation has been frustratingly persistent in some parts of the economy, like core services, a category that includes rent. But prices for core goods — a category that includes used cars — had been slowing for much of last year, with some prices even declining. There was a surprise uptick in core goods in December, however, which would be worrisome if it continues.
Other counterarguments to team transitory are that the Fed’s interest rate cuts kept market expectations of inflation lower. That may be true, but it is hard to know how much market expectations of inflation actually feed through to the real economy.
The fight is expected to rage on: it’s impossible to know what would have happened if the Fed had not raised interest rates. The only real way to get an answer would be to cut rates, a little (as a treat), and watch the reaction in inflation data. There’s the added benefit that cutting early would prevent the lay-offs and economic crunch that become more likely the longer that interest rates are high.
But the Fed’s not known for taking preventive action. Nor is it known for making decisions to settle fights between economists.
