Wonking out: What would a hard landing look like?

ON WEDNESDAY (Dec 15), the Federal Reserve announced that it plans to make monetary policy a bit less easy out of concerns over inflation. Some of the media coverage made it seem like a road-to-Damascus moment, a sudden repudiation of everything Jerome Powell and associates have been saying. But if you read the Fed's statement carefully, not so much: The Fed is still of the view that a lot of recent inflation is tr-tr-transit... OK, we cannot use the T-word anymore, so maybe say that it is fugacious?

The actual announcement says, "Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation". Sounds fugacious to me. And the Fed's projections still include a combination of falling inflation with falling unemployment.

There are good reasons for that optimistic assessment. But the Fed has been wrong about inflation so far. What if it is wrong again?

Let us revisit some history. Although we talk a lot about inflation in the 1970s, the real pain came in the 1980s, as Paul Volcker's Fed tried to bring inflation down. It succeeded, but at an enormous price.

Getting core inflation down to around 4 per cent from around 10 per cent involved a huge surge in unemployment that took a long time to reverse: Despite "morning in America", the unemployment rate did not get back to its pre-Volcker level until towards the end of the Reagan administration.

It is not totally clear whether this huge wave of unemployment was necessary. Influential research using state-level data argues that the main factor in the Volcker disinflation was a big change in public expectations that could conceivably have happened without such a severe recession. But for now the working hypothesis for most economists is still that it took a nasty, sustained slump to end the inflation of the 1970s.

Are we looking at something similar in our future? Probably not, for several reasons.

For one thing, despite high headline numbers lately, underlying inflation by the end of 2022 is not likely to be anywhere near 1980 levels. Standard measures are currently unreliable because of pandemic weirdness - who knew used cars could loom so large in the statistics?

But possibly more robust measures like the Atlanta Fed's "sticky price" inflation or the Dallas Fed's "trimmed mean" suggest that a Powell disinflation, if it has to happen, would start from 3 per cent or 4 per cent, not Volcker's 10 per cent. In fact, the starting point for such a squeeze would be roughly the end point of Volcker's squeeze, which raises the question of why we should even bother.

Back to that in a minute.

Even if we assume that we will have to get inflation down to 2 per cent from, say, 3 per cent or 4 per cent, that is only one-third or one-quarter of the 1980s adjustment. And there are reasons to believe that the cost would be even smaller than that comparison implies.

A real dilemma ahead

A number of economists have suggested that the current inflation looks more like 1946 to 1948, than like the 1970s. Comparing the 2 episodes is tricky, in part because we do not have standard measures of core inflation going back that far, and overall inflation was unstable as families still spent one-third of their income on food. But one rough-and-ready way to get something like core inflation for the 1940s is to look at service prices, which were much less volatile than goods prices.

It looks like a 5 or 6-point decline in underlying inflation, roughly comparable with what happened in the 1980s. But the cost of elevated unemployment was much lower.

If we count the "point-years" of excess unemployment - 1 year of 1 percentage point elevated unemployment counts as a point-year - the Volcker disinflation cost 14 such point-years, the '40s disinflation only one-third as much.

Why the difference? By 1980, America had experienced many years of high inflation, so it was hard to convince people that the inflation era was over. That was not true in the 1940s, when some prominent businessmen were still betting on the return of the Great Depression.

So where are we now? Elevated inflation has been going on for less than a year, which suggests that it should be relatively easy to get rid of.

That is, to the extent we want to. The Fed's 2 per cent inflation target was set a couple of decades ago, based to a large extent on economic analyses that have turned out to be wrong - particularly the belief that situations in which even zero interest rates were not low enough to yield full employment would be vanishingly rare. There is actually a very good case that we would be better off on average with 3 per cent or more inflation, than we would be returning to 2 per cent.

So there may be a real dilemma ahead. Suppose that we find ourselves a year from now with 3-ish per cent inflation, and it is clear that the Fed would have to impose at least a mild recession - costing hundreds of thousands if not millions of jobs, at least for a while - to get it back to 2 per cent. Would that be a price worth paying?

Right now the Fed is betting that this dilemma will not arise. Let us hope it is right. NYTIMES