Stumbling on Goldilocks

The US economy has been much more successful in recovering from the Covid crisis than it was in dealing with the aftermath of the housing bubble of the 2000s. As I noted in my last column, four years after the start After the 2007-09 recession, employment was still five million below its pre-recession peak. This time it has grown by almost six million.

And although there was a surge of inflation, it appears to have broken. This becomes especially clear if inflation is measured in the same way that other countries do. The harmonized consumer price index differs from the normal consumer price index in that it does not include owners' equivalent rent, an imputed cost of housing that no one actually pays and which is largely a lagging indicator; and by this measure, inflation has already slowed to about 2%, the Federal Reserve's inflation target.

Basically, the United States has quickly returned to full employment while experiencing a one-time jump in the price level without a sustained increase in inflation, the rate at which prices rise. Not bad, especially considering all the dire predictions that were made along the way.

But could we have done better? And to the extent we got it right, was it just luck? My view is that we have done very well, that the US response to the Covid crisis, in retrospect, was very close to optimal. But the miracle of 2023, the combination of rapid disinflation and a strong economy, has been something of a fluke. Policymakers thought that raising interest rates would cause a recession, and they raised them anyway because they believed such a recession was necessary. Fortunately, they were wrong in both cases.

What do I mean that the policy was almost optimal? Covid disrupted the economy in a way previously only associated with wartime mobilization and demobilization: there was a sudden large shift in the composition of demand, with consumers shifting away from in-person services and buying more. physical things, a change amplified and perpetuated by the rise of remote work. The economy could not adapt quickly to this transformation, so we ran into supply chain problems—insufficient capacity to deliver goods—along with excess capacity in services.

How should politics respond? There were clear arguments—perfectly detailed in a 2021 paper by Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Ivan Werning presented at the Federal Reserve's Jackson Hole conference that year—in favor of strongly expansionary monetary and fiscal policies that would limit the loss of employment in the service sector, even if this meant 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 inflation would become entrenched in the economy, and that lowering it again would require years of high unemployment. This was the infamous argument made by Larry Summers and others. But that argument turned out to be basically wrong; It was not just a bad forecast, something that can happen to everyone, but a misinterpretation of how the economy works. Although inflation lasted longer than the “Transitional Team” expected, it has subsided, as we predicted, without a large increase in unemployment. Specifically, inflation never became entrenched in expectations, as it did in the 1970s.

In fact, the United States has experienced the strongest recovery in the advanced world without recording significantly higher inflation than other countries.

So, it seems that American policymakers got it wrong rather than right. But, as I've already hinted, you could say it was a lucky coincidence.

It doesn't hurt to examine the projections made by members of the Federal Reserve Open Market Committee (FOMC) - which sets interest rates - in December 2022 and compare them with 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 actions would cause a recession and also that a recession was necessary. Their median forecast was that economic growth would virtually stagnate and unemployment would rise by about one percentage point, which would have triggered Sahm's rule, which links rising unemployment to recession. And if growth had truly stagnated, it probably would have turned negative, because big slowdowns in growth tend to lead to sharp declines in business investment.

Be that as it may, the extraordinary thing is that these were errors that were compensated for. The Fed's mistake on inflation could have led it to impose an unwarranted recession on an economy that didn't need one, but the rate hikes turned out to be appropriate, not to induce a recession, but to offset an increase in spending that otherwise way it could have been inflationary. Overall, the policy appears to have been correct, creating an economy that was neither too cool, suffering from unnecessary unemployment, nor too overheated, experiencing inflationary overheating.

Yes: policymakers stumbled upon 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 resistance to high interest rates is harder to explain, although immigration may have been a driving force: slow population growth was a popular explanation for secular stagnation, so an influx of working-age adults was possibly just what we needed.

I guess the most important thing is that, in macroeconomics as in life, it is important to be good, but it is also very important to be lucky. And this time we were lucky.

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