Early this year many economists held a very grim view about the prospects for reducing inflation without a major economic slowdown and a big rise in unemployment. One prominent economist declared that underlying inflation was at least 4.5 percent and that “all the hoped-for saviors” — that is, forces that might bring inflation down painlessly — “have come and gone.” Inflation, another declared, would be “sticky around 4 to 5 percent.”
Given those expectations, what actually happened amounts to a minor, or maybe not so minor, miracle. Growth, both in gross domestic product and in jobs, has remained solid. But standard measures of underlying inflation are now under 3 percent and falling. Fancier statistical models maintained by the New York Fed tell the same story, and say that underlying inflation has fallen by half since its peak last year.
Now, there may be some bumps in the months ahead, largely involving technical issues. Government statisticians have no trouble estimating, say, the price of eggs; but while they do their best, the methods they use to estimate the prices of services, such as health care, can sometimes produce implausible results that add noise to the data. No, the cost of health insurance didn’t fall 30 percent over the past year. And given noisy data, there may be a few bad inflation numbers in our future.
Nonetheless, the dramatic fall in underlying inflation this year is clearly real, and corroborated by many sources, notably business surveys. Voters, especially Republicans, may believe or claim to believe that inflation is still rising, but while this belief may be politically important, it’s just wrong.
So the big economic question of the moment is: What went right? How did Goldilocks come to the U.S. economy?
As an important new paper from Mike Konczal of the Roosevelt Institute points out, there are two main stories out there that might explain why U.S. inflation has come down so quickly and painlessly. For what it’s worth, these stories aren’t after-the-fact rationalizations, cobbled together to make sense of events nobody expected. On the contrary, several economists, myself included, were telling these stories even during the winter of our inflation discontent, arguing that the kind of soft landing — disinflation without recession — we now seem to be experiencing was indeed possible.
So score one for the optimists. But for reasons I’ll explain in a minute, it matters which of these two optimistic stories was right.
One of the two optimistic stories goes under the unlovely name of the “nonlinear Phillips curve.” To put that in something resembling English, in normal times there seems to be a negative relationship between unemployment and inflation, but it’s pretty weak, implying that the Federal Reserve’s strategy of cooling inflation by raising interest rates, and hence reducing overall demand, would have to cause a lot of unemployment to get inflation back down to an acceptable level. The claim, however, is that in an overheated economy, which we seemed to have last year, the relationship between unemployment and inflation gets much stronger, so that the Fed might need to cause only a modest rise in unemployment to yield a big decline in inflation.
The other optimistic story has, I believe, a better name, although I would say that, since I think I coined it myself: long transitory, a play on long Covid. This is the argument that as late as early 2023 inflation was still elevated because of lingering supply disruptions from the pandemic, but that inflation is coming down now because the economy is finally normalizing.
There could well be truth to both ideas. But the nonlinear Phillips curve explains why inflation might fall with only a small rise in unemployment; it doesn’t do as well in explaining what we’ve actually seen, which is falling inflation without any rise in unemployment at all. (The small uptick in August was probably just a statistical blip.)
Konczal tries to resolve the issue by comparing disinflation across different goods and services. He argues that if improving supply as pandemic effects fade is the main story, we should see inflation falling fastest for goods and services whose consumption has risen the most, because their availability has increased. And that is in fact what we see.
Why does this dispute among inflation optimists matter? Because of concerns that inflation might reaccelerate if the economy stays strong.
After all, if you believe that inflation fell rapidly because of cooling demand, you have to worry that if the economy heats up again, say, because the Fed stops its rate hikes too soon, inflation could quickly rebound. That’s much less of a concern if we’re mainly seeing the effects of post-Covid normalization.
So what I see as growing evidence in favor of the long transitory story is reassuring. That said, of course, policymakers need to stay vigilant.
This argument probably isn’t over. What shouldn’t be an issue, however, is the proposition that inflation has come down far faster than pessimists predicted, at no visible cost.
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