How many economists missed disinflation?
In economics, as in life, it’s really important to learn from your mistakes. The learning process begins when you say the magic words “I was wrong,” which sets you free to ask why you were wrong and do better next time. Those of us who failed to predict the big run-up of inflation in 2021-22 are, I think it’s fair to say, well along on that process.
But it’s not clear to me that economists who had predicted that getting inflation under control — it’s down a lot, although not all the way — would require years of very high unemployment are engaging in a similar reckoning. They should. In particular, they should ask themselves whether inflation pessimism was in part caused by a form of bias that has had negative effects on a lot of economic policymaking — not partisan bias, but the urge to sound serious by calling for hard choices and sacrifice.
Before I get to that, however, let me talk about what went wrong with so many recent economic predictions.
I’ve been looking at what you might call mainstream predictions about inflation and unemployment made late last year — economic projections by the
Federal Reserve and by professional forecasters surveyed by the Philadelphia Fed. Perhaps surprisingly, both more or less correctly predicted the inflation decline we’re actually seeing.
The survey of forecasters predicted consumer inflation (excluding volatile food and energy prices) of 3.5% for the whole of 2023; given actual price increases so far this year, this would require inflation for the rest of the year to run at 2.7%, which seems quite reasonable given recent data. The Fed predicted that the core personal consumption expenditures deflator, a similar measure, would rise 3.5% over the course of the year; this will also come close if inflation for the rest of the year is 3% or less, which again seems reasonable.
Both forecasts, however, assumed that disinflation would require a substantial rise in unemployment. The professional forecasters predicted 4.4% unemployment by the fourth quarter, the Fed 4.6%. Since the actual unemployment rate in July was only 3.5%, to meet those predictions would require that the economy fall off a cliff starting just about now — and there are no signs that this is happening.
Yet most of the criticism I heard of the Fed and others berated them for excessive optimism. Getting inflation down, a chorus of economists insisted, would require much bigger increases in unemployment. Most famously, Larry Summers declared that we would need something like two years of 7.5% unemployment to get inflation down to 2%, but others offered broadly similar if less extreme diagnoses.
OK, we haven’t reached 2% yet (and it’s not clear that we even should), but surely we’ve seen enough to conclude that such claims were wildly off base. So, have the pessimists come to terms with that reality?
Well, I’m still seeing a lot of excuses — two, in particular.
One is the claim that much of the progress against inflation is in some sense illusory, that underlying inflation is still well above 4%. Now, there are enough measures of underlying inflation out there that if you pick and choose you can still manage to be pessimistic, but the preponderance of the evidence — plus the results of hands-free algorithms that use a consistent procedure to extract the signal from the noise — suggests underlying inflation around 3% and dropping.
The other is the claim that disinflation pessimists were simply applying standard economic models, so that the fault lay in the models, not themselves.
But that’s simply not true. Standard models say that disinflation is very costly if persistent high inflation has become entrenched in expectations. And it was or should have been clear, even a year ago, that this wasn’t a good description of the current U.S. economy. That’s not 20-20 hindsight: I argued a year ago, at the peak of inflation pessimism, that analogies with the painful aftermath of the 1970s were all wrong. And I was, frankly, shocked to see smart economists blithely ignoring the obvious differences in circumstances.
Did I expect disinflation to come as painlessly as it has? No. Even inflation optimists clearly need to do some rethinking. But inflation pessimists really need to do what inflation optimists did a year ago, and ask how they got it so wrong, effectively calling for policies that would have put millions out of work.
As I said, it wasn’t partisanship; America’s right has become so divorced from empirical reality that it has played no role in this debate. What I do suspect, however, is that some very good economists got caught up in a version of the Very Serious People problem of the 2010s, in which the desire to seem hardheaded led many elite voices to obsess over budget deficits when they should have been focused on inadequate job creation.
The good news is that while the Fed did, in effect, try to engineer a recession to control inflation, it didn’t succeed: Despite rising interest rates, the economy just kept chugging along. Why that happened is another question. But pessimists really need to grapple with the fact that disinflation happened anyway.
This article originally appeared in The New York Times.