As the world was recovering from the pandemic, inflation shot up due to supply chain disruptions and sudden changes in demand patterns. While the demand shifts might have posed a challenge to price stability even in the best of times, the breakdown in supply chains made matters worse. The market could not respond immediately, so prices increased.
Recall that we initially experienced a car shortage simply because of a shortage of computer chips, a problem that took 18 months to correct. The issue was not that we had forgotten how to produce cars or lacked trained workers and factories. We were just missing a key component. Once it was supplied, automobile inventories expanded, and prices decreased — disinflation set in.
Housing provides another example of this temporary, self-correcting phenomenon. The loss of one million Americans under Donald Trump’s pandemic mismanagement ought to have lowered housing prices. But the pandemic also induced people to look for greener pastures. Major cities like New York came to seem less attractive than places like Southampton.
Increasing the housing supply in such places is not easy in the short term, so prices duly rose. However, owing to well-known asymmetries in how prices adjust to changing market conditions, they did not fall commensurately in the cities.
As a result, housing price indices went up. Now, as the effects of the pandemic have waned, prices have drifted slowly, reflecting that most leases last for at least a year.
What role did the US Federal Reserve play in all this? Given that its rate hikes did not help resolve the chip shortages, it cannot take any credit for the disinflation in car prices.
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Worse, the rate hikes probably slowed the disinflation in housing prices. Significant higher rates inhibit construction and make mortgages more expensive, forcing more people to rent instead of buy, driving up rental and CPI.
Food and energy spike
The pandemic-induced inflation was exacerbated further by Russia’s invasion of Ukraine, which caused a spike in energy and food prices. But, again, it was clear that prices could not continue to rise at such a rate, and many of us predicted that there would be disinflation — or even deflation (a decline in prices) in the case of oil.
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We were right. Inflation has indeed fallen dramatically in the US and Europe. Even if it has not reached the central bankers’ 2% target, it is lower than most expected.
Moreover, one must remember that the 2% target was pulled out of thin air. There is no evidence that countries with 2% inflation do better than those with 3% inflation; what matters is that inflation is under control. That is the case today.
Of course, central bankers will pat themselves on the back. But they had little role in the recent disinflation. Raising interest rates did not address the problem we faced: Supply-side and demand-shift inflation. If anything, disinflation has happened despite central banks’ actions, not because of them.
Markets largely understood this all along. That is why inflationary expectations remained tame. While some central bank economists claim this was due to their forceful response, the data tell a different story.
Inflation expectations were muted early because markets understood that the supply-side disruptions were temporary. Only after central bankers repeated their fears that inflation and inflationary expectations were setting in and that this would necessitate a long slog entailing high interest rates and unemployment did inflationary expectations rise.
Novel economic shock
Before the latest conflict in the Middle East, it was clear that a “victory” over inflation had been achieved without the large increase in unemployment that inflation hawks insisted would be necessary. Once again, the standard macroeconomic relationship between inflation and unemployment was not borne out.
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That “theory” has been an unreliable guide over the past quarter-century, so it was again this time. Macroeconomic modelling may work well when relative prices are constant and major economic changes revolve around aggregate demand, but not when there are large sectoral and concomitant relative price changes. When the post-pandemic inflation started more than two years ago, economists divided into two camps: Those who blamed excessive aggregate demand, which they attributed to large recovery packages and those who argued that the disturbances were transitory and self-correcting.
During the pandemic’s onset, uncertainty prevailed. Faced with a novel economic shock, predicting the duration of disinflationary forces was challenging. Few foresaw market resilience issues or the temporary monopoly power benefiting select firms due to supply-side disruptions.
But over the ensuing two years, studies of the timing of price increases and the magnitude of aggregate-demand shifts relative to aggregate supply largely discredited the inflation hawks’ aggregate demand “story.” It simply did not account for what had happened.
Whatever credibility that story had left, disinflation has further eroded its credibility. Fortunately for the economy, Team Transitory was right. Let us hope the economics profession absorbs the right lessons. — © Project Syndicate, 2023
Joseph E. Stiglitz, a Nobel laureate in economics, is a University Professor at Columbia University and Co-Chair of the Independent Commission for the Reform of International Corporate Taxation
