Honey, I shrank the economy's capacity

BACK in 2010, a group of conservative academics, economists and money managers signed an open letter warning that the efforts of the US Federal Reserve to support the economy would be dangerously inflationary. But the inflation never came. So 4 years later, Bloomberg reached out to as many of the signatories as it could to ask what happened.

Not one was willing to admit having been wrong.

I don't want to be like those guys. So I'm currently spending a fair bit of time trying to understand why my relaxed view of inflation early last year has been refuted by events. What I want to do today is share where I am now on that topic and what my current take says about future policy.

Last spring, the debate was focused on the American Rescue Plan, the Biden administration's large spending package. A number of economists, including Larry Summers, Olivier Blanchard and Jason Furman, warned that this package would overstimulate the economy - that output and employment would soar to levels that would create a lot of inflationary pressure.

Those of us on the other side argued that the risks of excess spending were much less than they warned - that large parts of the Biden package, such as aid to state and local governments, would end up being disbursed gradually over time and therefore not have that much of an inflationary effect. To use the jargon, I argued that the American Rescue Plan would have a low "multiplier".

So here's the funny thing: The multiplier does indeed seem to have been low. The economy has expanded fast, but it started in a deep hole and at this point is still, if anything, a bit below its pre-pandemic trend.

Digging deeper

The Congressional Budget Office regularly publishes projections of "potential" gross domestic product (GDP) - the level of output consistent with stable inflation. So far the official numbers till the third quarter of 2021, extended by private estimates of growth in the fourth quarter, still put us slightly below what we thought the economy's potential was going to be.

We've seen a strong recovery in employment, but we're still significantly below pre-pandemic levels.

The point is that if you had told me a year ago that this is what current output and employment numbers would be, I wouldn't have predicted soaring inflation. To put it another way, my expectations of a relatively muted effect of government outlays on demand were more or less vindicated. But of course, my expectations of moderate inflation weren't. So what happened?

Part of the answer lies in supply chain issues. Overall demand hasn't grown all that fast, but fear of face-to-face interactions has skewed demand away from services towards goods, over-straining shipping and in some cases manufacturing capacity. These issues account for a lot of recent inflation, but in a way, they don't worry me too much: The private sector has huge incentives to get stuff moving, so sooner or later, supply chain issues will fade away.

However, it's not just the supply chain; it's obvious that we're now experiencing widespread labour shortages, even though employment is still below its pre-pandemic trend.

I mentioned that the employed percentage of prime-age adults has generally been a good indicator of the state of the labour market. Another good indicator is the rate at which workers are quitting their jobs: Quits are high when people believe that new jobs are easy to find. Normally, these 2 measures move in tandem, but something has changed.

You can see the close relationship between the 2 measures before 2020. Since then, however, the relationship seems to have shifted so that a labour market that seems only okay judging by the employment rate looks extremely tight judging by the number of people who are quitting. And wages are rising rapidly, which suggests that quits are telling the real story.

Unreliable projections

What we're seeing, of course, is the Great Resignation - which is also, to an important extent, a Great Retirement. A recent blog post from the International Monetary Fund shows that there has been a surge in the number of older Americans (and Britons) choosing not to be in the labour force. Now, a labour market in which jobs are easy to find and workers can bargain for higher wages is a good thing. But the fact that labour markets are so tight, even though employment and real GDP are below pre-pandemic projections, suggests that we can't rely on those projections to assess the economy's productive capacity. For whatever reason or reasons - presumably, reasons linked to Covid-19 - the US economy apparently can't sustainably produce as much as we expected.

And that in turn tells us that it is time for policymakers to pivot away from stimulus - in particular, that the Fed is right to be planning to raise interest rates in the months ahead. As I read the data, it doesn't call for drastic action: The Fed should be taking its foot off the gas pedal, not slamming on the brakes. But that's a story for another day.

For now, the moral is that Covid-19 means that we can't assess where we are simply by comparing our situation with the pre-pandemic trend. That trend, at least, no longer appears to be our friend. NYTIMES