Stumbling upon Goldilocks

The US economy has been much more successful in recovering from the Covid shock than in dealing with the consequences of the housing bubble of the 2000s.

As I noted in my last article, four years after the start of the 2007-2009 recession, employment was still 5 million below its pre-recession peak.

This time there are almost 6 million more.

And although there was a wave of inflation, it appears to have stopped.

This is especially clear if you measure inflation as other countries do.

The harmonized consumer price index differs from the regular consumer price index in that it does not include equivalent landlord rent, a notional cost of housing that no one actually pays and which is largely a lagging indicator; and thanks to this measure, inflation has already fallen to around 2%, the Federal Reserve’s inflation target.

Crucially, the United States quickly restored the situation full employment experiencing a single increase in the price level without a sustained increase in inflation, the rate at which prices rise. Not bad, especially considering all the dire predictions made along the way.

But we could have done it Better?

And to the extent that we did well, were we simply lucky?

Conclusion

My view is that we did very well and that the US response to the Covid shock was, in retrospect, quite close to optimal.

But the miracle of 2023, the combination of rapid disinflation and a strong economy, was something of an accident.

The authorities thought that raising interest rates would cause a recession and raised them anyway because they believed that such a recession was necessary.

Luckily, they were wrong in both aspects.

What do I mean by the policy was close to optimal?

COVID has disrupted the economy in ways previously only associated with wartime mobilization and demobilization:

There has been a sudden major shift in the composition of demand, with consumers moving away from in-person services and purchasing more physical goods, a shift amplified and perpetuated by the rise of remote working.

The economy failed to adapt quickly to this change, so we found ourselves facing supply chain problems (inadequate ability to deliver goods) along with excess capacity in services.

How should policies respond?

There was a clear, very formalized argument in a 2021 paper by Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Ivan Werning presented at the Fed conference in Jackson Hole that year, for a highly expansionary monetary and fiscal policy which limited job losses in the service sector. even if this would mean a temporary increase in inflation.

And that’s more or less what happened.

The big risk in pursuing such a policy was the possibility that the rise in inflation would not be temporary, that the inflation would become entrenched in the economy, and that a new decline would require years of high unemployment.

This was the infamous argument made by Larry Summers and other.

But that argument turned out to be fundamentally flawed:

not just a bad forecast, which happens to everyone, but a poor understanding of how the economy works.

Although inflation lasted longer than the Transition Team expected, as we had predicted, it fell without a large increase in unemployment.

In particular, inflation has never become entrenched in expectations, as it did in the 1970s.

In fact, the United States had the the strongest recovery in the world advanced without experiencing significantly higher inflation than other countries.

It therefore seems that the US authorities are more or less right.

But as I have already suggested, it could be said that it was a lucky accident.

It is instructive to look at the projections made by members of the Federal Reserve’s Open Market Committee (which sets interest rates) in December 2022 and compare them to what actually happened.

The FOMC had been raising rates since early 2022 in an effort to control inflation, and it was clear from the projections that members believed their efforts would cause a recession and that a recession was necessary.

Their average projection was that economic growth would nearly stagnate and unemployment would rise by about one percentage point, which would trigger the Sahm rule linking rising unemployment to recession.

And if growth was really stagnant, it probably would have gone negative, because they tend to cause big slowdowns in growth heavy falls in corporate investments.

What actually happened is that the economy proved much more resilient to higher interest rates than the Fed expected, so growth continued to advance and unemployment did not rise significantly.

But inflation still fell, falling below the Federal Reserve’s projections.

So the economy surprised the Federal Reserve in two ways, both good.

It turned out that disinflation did not require an increase in unemployment; But it turned out that the rate increases did not hurt employment as expected.

My view is that the first mistake, that is, believing that we needed high unemployment, is hard to excuse – there were very good reasons to believe that the 1970s were a bad model for post-pandemic inflation – while no one could have known that the economy would contract. backs in the face of high rates.

But I would say that, right? Because I didn’t make the first mistake, but I made the second.

In any case, what is noteworthy is that these were compensation errors.

The mistake of Federal Reserve Inflation could have led it to impose a gratuitous recession on an economy that didn’t need it, but the rate increases turned out to be appropriate, not to induce a recession but to offset an increase in spending that might otherwise have been inflationary.

Overall, the policy appears to have been correct: to create an economy that was neither too cold and suffering from unnecessary unemployment, nor too hot and subject to inflationary overheating.

Yes: Politicians have run into Goldilocks.

What went well?

As I said, the claim that inflation would be difficult to control never made much sense, given what we knew.

The economy’s resilience in the face of high interest rates is harder to explain, although a driving force may have been immigration:

Slow population growth was a popular explanation for secular stagnation, so an influx of working-age adults may have been just what we needed. .

I guess the most important point is that in macroeconomics, as in life, it is important to be good, but also very important to be lucky.

And this time we were lucky.

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