The Lessons of Pandemic Inflation

As economists and pundits continue to debate why Americans aren’t feeling better about the economy despite healthy growth and falling rates of inflation, the inflation outlook itself continues to improve. Last week, the Commerce Department reported that, according to a measure that the Federal Reserve watches closely—the Personal Consumption Expenditure (P.C.E.) deflater—consumer prices rose by just three per cent from October, 2022, to October, 2023. That’s not far above the Fed’s target of two per cent, and, in the case of some items, including gasoline and used vehicles, prices are falling, not merely going up at a lower rate.

As usual, the story can be complicated by considering different measures of price rises. For reasons that I’ve never found wholly convincing, many economists focus obsessively on “core” inflation, which excludes the prices of energy and food. According to the P.C.E. core index, the core rate is still running a bit higher: 3.5 per cent. But, in the three months from August to October, it rose at an annualized rate of just 2.2 per cent. “The short-term rate of price increases is now very close to target, and slowing,” the economic advisory firm Pantheon Macroeconomics noted in a client circular.

Given all the furor over inflation when it was rising rapidly in 2021 and 2022, this year’s big drop is surely worthy of more inspection than it has received. Since June of last year, when the headline rate hit 9.1 per cent, virtually all measures of price rises have fallen dramatically. And with the latest declines even some erstwhile inflation hawks have acknowledged that the outlook is now benign. “I’m later to proclaim it than many others but we’re almost at the soft landing,” the Harvard economist Jason Furman wrote on X (formerly Twitter) after the P.C.E. numbers were released. On the other side of the debate, Claudia Sahm, a former Federal Reserve economist who has vigorously defended the $1.9 trillion American Rescue Plan of 2021, which some of the hawks blamed for driving inflation higher, titled her latest Substack post “I was right.”

It can’t be denied that inflation has declined more rapidly than many economists (and the Fed) expected, and that this fall has coincided with sustained growth in employment and gross domestic product despite higher interest rates. In June of last year, Lawrence Summers, another Harvard economist, said, “We need five years of unemployment above five per cent to contain inflation—in other words, we need two years of 7.5 per cent unemployment or five years of six per cent unemployment or one year of ten per cent unemployment.” But inflation has come down even as the unemployment rate has stayed below four per cent for twenty-one months, a spell of low joblessness that hasn’t been matched since the nineteen-sixties. The argument that a recession was necessary to break the back of inflation turned out to be flat wrong.

Why so? Part of the explanation is that the hawks were relying on textbook models that explain inflation mainly in terms of the level of over-all demand in the economy, as proxied by the level of unemployment or G.D.P. Bringing down inflation in these models requires sacrificing some output and employment. (The exact amount is known as the “sacrifice ratio.” ) A new study from the White House’s Council of Economic Advisers (C.E.A.) illustrates the shortcomings of this approach when it is applied to recent history.

To explain the path of inflation throughout the past decade, the C.E.A. used a statistical model that incorporated past inflation rates, an index of expected inflation, import prices, and the amount of slack in the labor market, measured by the difference between the actual unemployment rate and an estimate of the full-employment rate. When this model was applied to the recent data for core P.C.E. inflation, it left “most of the excess inflation of 2021, 2022, and 2023 unexplained . . . suggesting that we must go beyond the variables enumerated in the model to explain the rise and fall of pandemic inflation,” the C.E.A. reported in a blog post last week.

What was missing from the model? The most obvious thing was anything specifically having to do with the pandemic, and its disastrous impact on global supply chains. To remedy this omission, the C.E.A. added an extra variable: an index of supply-chain disruptions developed by the Federal Reserve Bank of New York, which incorporates things such as shipping and airfreight rates. (In 2020 and 2021, some shipping rates more than quadrupled. In the past year or so, they have nearly fallen back to pre-pandemic levels.) With the supply-chain index included as an explanatory variable, the model was able to explain much more of the inflation spike. And decomposing the findings indicated that changes in the supply-chain index could explain more of the surge in inflation than any other factor. In other words, the data suggest that the snarling of the global supply chain was the primary driver of the inflation spike and its subsequent unwinding.

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