Inflation and the scariest economic paper of 2022

A Now Hiring sign in Orlando, Florida on April 17, 2021. Photo: ...


A Now Hiring sign in Orlando, Florida on April 17, 2021.


Photo:

Paul Hennessy/Zuma Press

Scariest economic paper of 2022 says labor markets remain extremely tight, core inflation is high and possibly rising, and several years of very high unemployment could be needed to get inflation under control . The paper is a careful empirical exploration by macroeconomist Larry Ball of Johns Hopkins with co-authors Daniel Leigh and Prachi Mishra of the International Monetary Fund published by the Brookings Papers on Economic Activity. This shows why the Federal Reserve will likely have to maintain its war on inflation, even if unemployment continues to rise.

Economists use the slowdown in the labor market to help predict inflation. Typically, they look at the unemployment rate, but using the vacancy-to-unemployment ratio to measure the labor market downturn provides a clearer picture. Analysts who focused only on the unemployment rate mistakenly believed that the labor market still had a substantial slowdown in 2021 and judged wage and price inflation to be transitory. The big surge in inflation that followed left them perplexed. MM. Ball, Leigh and Mishra find that the tight labor market itself added 3.4 percentage points to core inflation in July 2022.

The paper also argues, convincingly in my view, for a different measure of core inflation. Fluctuations in energy and food prices are usually driven by factors beyond the control of macroeconomic policy makers. Geopolitics and weather have raised the rate of inflation in recent years. Falling gasoline prices are temporarily reducing the rate of inflation now. This is why economists since the 1970s have focused on “core” inflation, which excludes food and energy.

But food and energy aren’t the only things people buy that are subject to supply volatility. Prices for new and used cars, for example, have fluctuated over the past two years for reasons that are mostly unrelated to the strength of the overall economy. Normal inflation and core inflation are based on averages of price increases and can be skewed by large changes in outlier categories. The median inflation rate calculated by the Federal Reserve Bank of Cleveland removes outliers to remove these distortions.

Median inflation is a better statistical measure of underlying inflation that policy makers can actually control. This is worrying because while the Fed’s preferred headline inflation fell to zero in July and annual inflation excluding food and energy stabilized around an annual rate of 4%, median inflation for Personal consumption spending shows no signs of moderating and has settled at an annual rate of 6.6% over the past three months.

The scariest part of the new paper, however, is when the authors use their model to forecast the unemployment rate that would be needed to bring inflation back to the Fed’s 2% target. The authors present a range of scenarios, so I ran their model using my own assumptions. I assumed the job market would cool on its own as job vacancies drop to two-thirds of what they were pre-Covid. I also assumed that inflation expectations would fall back to where they were before Covid and that recent good news on gasoline and other volatile prices will continue to arrive for the rest of 2022.

Under these assumptions, which are more optimistic than the authors’ median scenario, if the unemployment rate follows the Federal Open Market Committee’s June median economic projection that unemployment will only increase to 4.1%, then the rate inflation rate will still be around 4%. at the end of 2025. To bring the inflation rate to the Fed’s 2% target by then would require an average unemployment rate of around 6.5% in 2023 and 2024.

There is, of course, enormous uncertainty with this forecast. If companies believe that low inflation is coming and act accordingly, inflation could come down without a sharp rise in unemployment. On the other hand, if the labor market does not return to its pre-Covid state, or if there are more adverse supply shocks, the outlook could be more painful.

What should the Fed do? Four things: First, pay more attention to the ratio of job creation to unemployment and median inflation, as it gauges the tightening of labor markets and the underlying inflation rate. Second, the new paper shows how much easier it will be to fight inflation if expectations stay in check. The Fed is expected to follow up on Chairman Jerome Powell’s tough speech in Jackson Hole with meaningful action such as a 75 basis point hike at the next meeting. Third, be prepared to accept unemployment rising above 5% if inflation is still out of control. Finally, stabilizing at an inflation rate of 3% is probably healthier for the economy than stabilizing at 2%. So, while fighting inflation should be the sole focus of the central bank today, at some point the Fed should reassess the meaning of victory in this fight.

Furman, a professor of economic policy practice at Harvard University, served as chairman of the White House Council of Economic Advisers from 2013 to 2017.

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