We got lucky with the Fed stumbling into Goldilocks
The U.S. economy has been far more successful at recovering from the COVID shock than it was in dealing with the aftermath of the housing bubble of the 2000s. As I noted in my latest column, four years after the 2007-09 recession began, employment was still 5 million below its prerecession peak. This time it’s up by almost 6 million.
And while there was a wave of inflation, it seems to have broken.
This is especially clear if you measure inflation the way other countries do. The harmonized index of consumer prices differs from the regular consumer price index in that it doesn’t include owners’ equivalent rent, an imputed cost of housing that nobody actually pays and is very much a lagging indicator; and by this measure inflation has already been cut to roughly 2%, the Federal Reserve’s inflation target.
Basically, the U.S. rapidly restored full employment while experiencing a one-time jump in the level of prices without a sustained rise in inflation, the rate at which prices are rising. Not bad, especially considering all the dire predictions made along the way.
But could we have done better? And to the extent that we got it right, were we just lucky?
My take is that we did very well, that the U.S. response to the COVID shock was, in retrospect, fairly close to optimal. But the miracle of 2023, the combination of rapid disinflation with a strong economy, was sort of an accident. Policymakers thought that raising interest rates would cause a recession and raised them anyway because they thought such a recession was necessary. Fortunately, they were wrong on both counts.
What do I mean by saying that policy was close to optimal? COVID disrupted the economy in ways previously associated only with wartime mobilization and demobilization: There was a sudden large change in the composition of demand, with consumers shifting away from in-person services and buying more physical stuff, a shift enlarged and perpetuated by the rise of remote work. The economy couldn’t adapt quickly to this shift, so we found ourselves facing supply-chain problems — inadequate ability to deliver goods — together with excess capacity in services.
How should policy respond? There was a clear case — nicely formalized in a 2021 paper by Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub and Ivan Werning presented at the Fed’s Jackson Hole conference that year — for strongly expansionary monetary and fiscal policy that limited job losses in the service sector, even though this would mean a temporary rise in inflation. And that’s more or less what happened.
The big risk in following such a policy was the possibility that the rise in inflation wouldn’t be temporary, that inflation would become entrenched in the economy and that getting it back down would require years of high unemployment. This was the argument infamously made by Larry Summers and others. But that argument turned out to be fundamentally wrong — not just a bad forecast, which happens to everyone, but a misunderstanding of how the economy works. Although inflation lasted longer than Team Transitory expected, it has, as we predicted, subsided without a big rise in unemployment. Notably, inflation never became entrenched in expectations, the way it did in the 1970s.
In fact, America has had the strongest recovery in the advanced world without experiencing significantly higher inflation than other countries.
U.S. policymakers, then, seem to have gotten it more or less right. But as I’ve already suggested, this was arguably a lucky accident
The economy proved far more resistant to higher interest rates than the Fed expected, so growth kept chugging along and unemployment didn’t rise significantly. But inflation fell anyway, coming in below the Fed’s projections. So the economy surprised the Fed in two ways, both positive.
So policymakers stumbled into Goldilocks.
I guess the larger point is that in macroeconomics as in life, it’s important to be good, but also very important to be lucky.