Does the Fed Deserve Credit for the Disinflation?

The Bureau of Labor Statistics on November 14, remarkably, announced that the US CPI had been unchanged in October (whether seasonally adjusted or not).  That is, the level of the CPI was unchanged, not the inflation rate, which was zero.  Of course, single-month numbers are too volatile to draw much of a conclusion.  Not every month will see the price of gasoline plunge by 5.0 %, as it did from September to October.

More informatively, the headline CPI inflation rate over the last 12 months was 3.2 %, far down from 6.5 % in 2022.  At the risk of tempting fate, one might say that the inflation battle is being won.

1. A rare immaculate disinflation

Contrary to what many economists had predicted, and also contrary to what many Americans still believe, the US inflation rate has, so far, come down without a major decline in economic activity or employment.  The economy has added 204,000 jobs per month over the last three months, well in excess of the long-term growth in the labor force.  As a result, unemployment remains under 4.0 %, almost the lowest level since the late 1960s.  GDP growth has been 2.3 % annualized so far this year, faster than the average for the US growth rate since the turn of the century.  This episode has been called “the immaculate disinflation,” since it occurred without loss of income or employment.

The story in other industrialized countries is similar, in that inflation rose in 2021-22 and fell in 2023. But the statistics elsewhere are not as good as in the US.  Other industrialized economies — the euro area, the United Kingdom, Canada and Japan — are growing more slowly.  Yet inflation is higher in Europe than across the Atlantic. (It remains very low in Japan.)

If one goes by the traditional rules of politics, the Fed and the US Administration should get political credit for the progress that was achieved during this period, regardless of whether they caused it or not.  But that criterion — traditional political practice — provides too low a bar. One can reasonably ask whether the policymakers are responsible in a causal sense for the apparent soft landing.

Certainly, two years ago they underestimated the inflation danger.  If the subsequent tighter monetary policy is responsible for the disinflation, it does not seem to have operated through the usual causal route of declines in output and employment.

2. Some alternative channels for monetary policy

Some possible mechanisms of transmission from interest rates to inflation do not operate via output or employment.  Three such channels are housing, the exchange rate, and commodity prices.

• Mortgage interest rates help determine the demand for housing. They have risen sharply over the last two years, the period when the Fed ended quantitative easing and tightened monetary policy. Some measures of housing prices indeed slowed sharply after mid-2022.
• Since March 2022, the month when the Fed began to raise interest rates, the dollar has appreciated more than 8 % against other major currencies. (This is by the narrow effective exchange rate) Admittedly, the dampening effect of appreciation on tradable goods prices is much weaker in the case of the United States than it would be in other countries.
• An insufficiently noticed channel is that high real interest rates put downward pressure on the prices of commodities like oil, minerals, and farm products. The global price index for all commodities fell more than 30 %, from March 2022 to October 2023 (as one might have predicted).

But neither the exchange rate, nor housing, nor even commodities, are the main story.

3. The best explanation

One possible explanation for why the fall in inflation has been accompanied by very little loss in economic activity is that the Phillips curve becomes much steeper when near full employment. That is, when unemployment is below 4 %, as it has been, and especially when job vacancies run above 7%, as they have, decreases in aggregate demand go almost entirely into lower inflation, rather than into lower economic activity.  This hypothesis could also help explain why inflation rose so rapidly in 2021-22.

Perhaps a better explanation is a favorably shift in aggregate supply.  Supply impediments that had been vexing in 2020-22 melted away in 2023. Snarled supply chains – clogged ports, goods order backlogs, input bottlenecks, worker shortages, and the rest of the Covid19-related disruptions that so dominated life in 2020-22 – eventually straightened themselves out.  The Global Supply Chain Pressure Index produced by the Federal Reserve Bank of New York shows supply disruptions peaking in December 2021 and declining steadily after April 2022.  Apparently, the invisible hand, which had gone AWOL, returned to its normal task of facilitating the smooth operation of the economy.

A favorable shift in the aggregate supply relationship should allow lower inflation for a given rate of economic growth.  Growth in 2022 and 2023 has gently declined relative to the overheated rate of expansion in 2021. (It really looks like a soft landing!)  The withdrawal of US monetary stimulus can explain why the favorable shift in the relationship showed up in the form of a 2023 decline in inflation, rather than in the form of accelerated GDP growth. In other words, if the Fed hadn’t raised interest rates after March 2022, chances are that the overheating of the economy would have continued, notwithstanding the favorable supply shift; inflation would still be high.  Very likely, the higher inflation would have started to become embedded in expectations by now.  The bottom line is that the Fed should get credit for lowered inflation after all.