The Lessons of Pandemic Inflation

2023 12 08

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In “The Lessons of Pandemic Inflation” John Cassidy writes, “As the inflation rate continues to fall, a new White House study emphasizes the central role that supply-chain disruptions have played in the economy.”

Supply chain disruptions, downstream from the COVID recession and rapid recovery therefrom ARE the key factors in distinguishing this inflation from others. But supply chain disruptions alone are “Hamlet” without the Prince of Denmark.  While supply chain disruptions are influential, the Federal Reserve ultimately holds the reins in controlling inflation. If we view the economy as a vehicle, the smoothness of the road dictates how swiftly the vehicle can move, yet it is the driver who controls its speed.

Major economic shocks like COVID and its aftermath cause fluctuations in the supply and demand for various goods and services. Consequently, substantial adjustments in relative prices become necessary to reallocate resources in response to these shifts. However, due to the differing speeds at which prices can react and the inability of some prices to decrease, relative price adjustments compel the average of all prices to rise. The Fed must engineer a certain level of average inflation temporarily to facilitate these necessary adjustments.  It did so and it vindicated “Team Temporary.”

Nevertheless, the Fed probably allowed more inflation than was necessary.  It allowed the temporary surge, necessary for a time, to go on too long and reach too high levels.  The Fed was not perfectly all seeing but compared to not allowing enough inflation and prolonging high unemployment as the Bernanke-Yellen Fed did after 2008, there is much to praise.

Cassidy's assertion that pessimists like Larry Summers in 2020 were mistaken in believing that only prolonged high unemployment could mitigate inflation is justified. They relied on a "textbook" model based on inflations of the 1970s, where adjustments in relative prices were hindered by expectations of high inflation. In this scenario, prices of items that adjust more slowly continued to rise, compelling the Fed to permit further price increases elsewhere. Only gradual adjustments in relative prices allowed for a return to full employment with low inflation.

But the “textbook” model did not apply this time.  Expectations remained low.  Only from about September 2021 to March 2022 were expectations as measured by the Treasury Inflation Protected Security (TIPS) above the Fed’s target inflation rate of 2% of the Price of Consumer Expenditure (PCE) index. From March 2022 when the Fed finally raised the Effective Federal Funds Rate, expectations of inflation, as indicated by TIPS, plummeted sharply. The Fed was free to reduce inflation rapidly without causing unemployment. It appears that the hoped for soft landing (perhaps “cruising speed” is a better metaphor) is within reach.

[Standard bleg:  Although my style is know-it-all-ism, I do sometime entertain the thought that, here and there, I might be mistaken on some minor detail.  I would welcome what the diplomats call “a frank exchange of views.”😊]