It has been a good week on the inflation front. First we had a flat month for the Consumer Price Index — zero inflation in July. Then we saw an actual decline in the Producer Price Index.
Naturally, there is a lot of pushback against the good news. I’ve been seeing many warnings against believing those who claim that the problem of inflation has been solved. The thing is, I don’t know who is supposed to be making that claim. Every economist I know believes that America still has high underlying inflation. The real question is how hard it will be to get that underlying inflation down — whether we’re going to need an extended slump like the one we went through in the 1980s. And the answer to that question depends a lot on whether you think our current situation resembles that in 1980.
First, about the good news: One of the most durable and successful concepts in macroeconomics is the distinction between headline inflation and “core” inflation, which excludes highly volatile prices. The traditional calculation of core inflation excludes food and energy; that calculation has been called into question given the strange disruptions and price movements we’ve seen in the era of Covid, but the traditional measure is good enough for today’s newsletter. Here are recent monthly rates of overall and core inflation:
Until July, headline rates were more or less consistently running well above core inflation; now, with gasoline prices falling, supply chain problems easing and so on, we’re seeing that difference reverse itself. The result is likely to be several months, at least, of fairly low inflation.
But, as I said, underlying inflation remains high, at least by the standards of the past 30 or so years. There are many competing estimates of that underlying rate, but by and large they tend to be in the range of 4 percent to 5 percent, compared with a Federal Reserve target of 2 percent inflation.
So how hard will it be to achieve that target?
The last time we saw inflation rates this high was at the beginning of the 1980s. Comparisons between data then and now are a bit tricky, because the Bureau of Labor Statistics has changed the way it estimates inflation. But it has produced estimates of the inflation rates it would have reported in the past if it had been using modern methods. If we compare those estimates for 1980 with recent inflation — this time over the past year — you can see that today’s inflation is lower than it was in 1980, but not all that much lower:
And getting 1980’s inflation down was a painful process. We tend to look at the Reagan-era economy through rose-colored glasses, partly because conservatives have spent decades glorifying it. But the reality was that America went though a long period of very high unemployment after the Fed began cracking down on inflation:
And one point I haven’t seen made is that all this unemployment didn’t get inflation down to 2 percent; back in the 1980s the Fed was content to stabilize inflation at around 4 percent. So right now we’re faced with the need to achieve a disinflation comparable with the one engineered by Paul Volcker (unless the Fed changes its target — but that’s a discussion for another day).
So why imagine that this time will be easier? The answer goes back to the reason (most) economists believe that disinflation was so hard in the 1980s. Back then, the story goes, everyone had come to expect high inflation in perpetuity. Wages and prices were being set based on that expectation, so inflation became self-sustaining. Disinflation required squeezing the economy hard and long enough to break that self-sustaining cycle.
And while actual inflation now doesn’t look very different from what it was in the 1980s, expectations about future inflation look very different indeed. We can compare expected inflation rates over the next year and the next five years from then and now; the 1980 data (for February 1980) are from the Michigan Survey, the 2022 data from the New York Fed:
Back then, the public expected roughly 10 percent inflation in perpetuity; today, the public expects inflation to be somewhat elevated in the near term but drop back to normal levels soon.
The story for professional economic forecasters is similar. In the early 1980s Blue Chip forecasters expected around 8 percent inflation over the next 10 years; now they expect less than 3 percent, and financial markets expect inflation of less than 2.5 percent.
You might ask why, if expected inflation remains low, actual inflation is so high. The answer probably is that the U.S. economy is currently overheated in a way it wasn’t in 1980. And if that’s right, getting inflation down requires cooling the economy off, but not putting it through an extended slump.
So that’s the case for saying that 2022 isn’t 1980. Should we believe it?
Well, this relatively optimistic story isn’t concocted on the spot to downplay our problems; it’s squarely based on standard economic models. And my own experience is that when I make big prediction errors, it’s usually because I’ve decided that standard models won’t apply, then been unfavorably surprised to find them working after all. So I believe in a (relatively) optimistic inflation scenario … I think.
But even this optimistic scenario still involves cooling off the U.S. economy through interest rate hikes. So if there really are economists who believe that the inflation problem has already been solved, I’m not one of them.