From an economic point of view, 2023 will go down in the record books as one of the best years ever — a year in which inflation came down amazingly fast at no visible cost, defying the predictions of many economists that disinflation would require years of high unemployment.
So far, at least, the public seems unwilling to believe the good news, or to give the Biden administration any credit. But this column isn’t about the apparent gap between voter perceptions and reality. It is instead about the unwillingness of some influential economists and officials to accept the fact that they got it wrong.
Why should we care? This isn’t about scoring personal points — although I’m a big believer in owning up to your past errors — it’s how you learn, and it’s also good for the soul. What I’m concerned about is that clinging to a view of the economy that has been disproved by recent events makes it more likely that we’ll mess this up, putting the economy through a recession that, it turns out, we didn’t and don’t need to control inflation.
How amazing has the economy been? As recently as March, the Federal Reserve committee that sets monetary policy projected that we’d end this year with 4.5 percent unemployment and with the Fed’s preferred “core” measure of inflation running at 3.6 percent. Last week, the same group projected year-end unemployment of only 3.8 percent and core inflation at only 3.2 percent. But actually the news is even better, because that last number is inflation for the year as a whole; over the six months ending in October, core inflation was running at 2.5 percent, and most analysts I follow believe that when November data come in later this week, it will show inflation down to around 2 percent, which is the Fed’s long-run target.
Soft landing achieved.
How did we pull that off? The answer seems fairly clear. Economists who argued that the inflation surge of 2021-22 was “transitory,” driven by disruptions caused by the Covid pandemic and Russia’s invasion of Ukraine, appear to have been right — but those disruptions were bigger and longer lasting than almost anyone realized, so “transitory” ended up meaning years rather than months. What happened in 2023 was that the economy finally worked out its postpandemic kinks, with, for example, supply chain issues and the mismatch between job openings and unemployed workers getting resolved.
This isn’t casual speculation. A combination of rising employment and falling inflation is exactly what you’d expect in an economy with improving supply chains. It’s also what you see when you look at the economy in detail: the fastest-growing sectors have had the biggest declines in inflation. And statistical models of inflation that include supply chain measures track inflation in recent years in a way that more conventional models don’t.
But many economists who were wrongly pessimistic about inflation — most prominently Larry Summers, although he isn’t alone — remain unwilling to accept the obvious. Instead, they argue that the Fed, which began raising interest rates sharply in 2022, deserves the credit for disinflation.
The question is, how is that supposed to have worked? The original pessimist argument was that the Fed needed to create a lot of unemployment to reduce inflation. As best I can tell, the argument now is that by acting tough the Fed convinced people that inflation would come down, and that this was a self-fulfilling prophecy.
There is, as far as I can see, no evidence at all for this story. While financial markets may pay close attention to the Fed’s pronouncements, producers and workers, who set prices and wages, don’t; they base their decisions on what they see around them.
There are some historical echoes here. Around a decade ago, some economists and policymakers insisted that slashing government spending would actually increase employment, by inspiring higher investment; I mocked this view, which proved utterly wrong, as belief in the Confidence Fairy. What we’re seeing now might be called belief in the Credibility Fairy.
To be clear, I don’t fault the Fed for having raised rates in the past. Last year we didn’t know that the inflation story would turn out this well, and to be fair, rate hikes have not, in fact, caused a recession, at least so far.
What worries me is the future. By and large, the same people who were wrongly pessimistic about disinflation are now warning the Fed against cutting interest rates quickly. Why? Well, if you believe that any rise in inflation will be very hard to reverse, and also believe that the Fed’s perceived toughness was crucial in getting inflation down, I guess you’re willing to run big risks of recession to preserve the Fed’s inflation-fighting credibility. But neither belief is supported by the evidence.
Has the war on inflation been definitively won? No. But recession looks like a bigger risk than resurgent inflation. And I worry that this risk will be increased if policymakers listen to people who are reluctant to admit that they got the inflation story wrong and are clinging to a false theory about how we got inflation down.
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