Lessons (So Far) From The Inflation Bubble Of 2021-3

By Simon Wren-Lewis, December 12, 2023

Simon Wren-Lewis is Emeritus Professor of Economics and Fellow of Merton College, University of Oxford.

Inflation went up, but now it’s coming down again. Not just in the UK, but pretty well everywhere. What macroeconomic lessons can we learn from this, and what questions still remain? Were ‘team transitory’ right after all? Were central banks too slow to raise rates, and once they started rising did they rise too fast?

The preliminary point to make is that inflation is not the cost of living. A period where inflation goes up and then comes down again means prices end up a lot higher at the end of this period than they were at the start. Those whose incomes have not matched the inflation they have experienced will be worse off, perhaps substantially so. For some who were already finding it hard to make ends meet, that is a very serious problem, which has not gone away just because inflation has fallen.

What should now be well understood is that this period of high inflation was not just about high energy and food prices. There were additional supply problems that pushed up prices, but more importantly labour markets in most of the major economies were also tight. Almost without exception, unemployment in 2022 was lower than at any time this century in the United States, Germany, France and the UK.

This meant that any increase in energy and food prices was likely to lead to some increase in wage inflation. This in turn would make the inflationary shock caused by higher food and energy prices more persistent, because firms not producing energy or food would pass on much of any increase in labour costs. To avoid this turning into a permanent increase in inflation, central banks raised interest rates in the US, UK and Euro area.

Were central banks too slow in raising interest rates? It is important to understand that central banks cannot and should not try to always keep inflation at target. When the relative price of commodities increases, it would be deeply damaging to try and reduce all other prices so that aggregate inflation did not rise. So there was always going to be an inflationary bubble in 2021-3. The issue is whether central banks could have moderated it more than they did.

It is also important to remember that in 2021 the main concern was and should have been ensuring a full recovery from the pandemic. Few anticipated the size of the inflationary shock (i.e that Russia would invade Ukraine, or that there would be so many supply side bottlenecks), and the pandemic made it difficult to read the state of the labour market. My own view, and in contrast to many others including various Lordships, is that central banks were right to delay raising rates until 2022. Once they understood that the recovery from the pandemic had been strong and that as a result the labour market was tight, they acted by raising rates pretty fast.

The fact that inflation is now falling quite rapidly strongly suggests that central banks have done enough to stop this energy and food price shock leading to permanently higher inflation. What we don’t know yet is whether they did too much, because the lag between nominal interest rate increases and falls in economic activity can be quite long. [1] However we can still make one important point.

When inflation was near its peak some economists (let’s call them the inflation pessimists) argued that a significant period of depressed economic activity would be necessary to bring inflation back down to be close to the 2% target. Only when unemployment was significantly higher than it is today, they suggested, would wage inflation start to fall back towards levels that are consistent with a 2% target.

We now know that that argument is almost certainly wrong. Wage inflation has fallen in the US and elsewhere without any large increase in unemployment. Of course unemployment may still rise because of the delayed effect of higher interest rates, but it is a bit of a stretch in the US at least to suggest that falling wage inflation in the US is a response to expectations of above trend unemployment.

What is not often discussed is that current macroeconomic theory does not suggest a period of significantly higher unemployment is necessary to reduce wage inflation. In this sense the inflation pessimists could be accused of being old fashioned. The idea that ‘if it’s not hurting it isn’t working’ comes from a traditional Phillips curve, where price and wage setters only look at past inflation when forming expectations about future inflation. The key point about a central bank trying to hit an inflation target is that price and wage setters take the actions of that central bank into account when forming expectations.

If the central bank has credibility (an overused word simply meaning here that central banks will be successful in hitting their inflation target), then this anchors future expectations about inflation at the inflation target. Wage and price setters know that inflation will come down to 2% once inflation shocks disappear or excess demand is eliminated, and so form their expectations accordingly. In this situation, there is no need for a period of excess labour or goods supply to bring inflation down. To use another much overused macroeconomic cliche, soft landings are quite possible and should be what central banks aim for.

Of course central banks can still get things wrong. They may not do enough to eliminate excess demand, in which case inflation above target will persist. They also may do too much to deflate demand leading to a period of excess supply, which could lead to inflation undershooting it's target. This second possibility is still very real in the UK and Europe, although it is looking less likely in the US.

As De Grauwe and Yi show, getting inflation down in the 2020s has been much easier than in the 1970s. This is partly because the inflationary shock was more short lived (gas prices have fallen and post-pandemic supply disruption is over, although food prices remain high) so no permanent contraction in supply was required. However it is also because we now have independent central banks with inflation targets, and a recent history where inflation has been close to target (so these central banks have credibility).

If the inflation pessimists, who thought a period of excess supply and higher unemployment was necessary to get inflation down, have been proved wrong, have ‘team transitory’ been proved right? Well that depends on what ‘team transitory’ believed and said. For the sake of exposition, let me define team transitory as saying that inflation would have come back to target without the large increase in interest rates we have actually seen.

This question is difficult to judge, because we do not know what the path of inflation would have been if central banks had not raised interest rates so much. As someone who initially argued against the size and speed of interest rate increases, it would be nice to answer yes, I was right. A great deal will depend on what happens to economic activity and inflation over the next year or so. There seem to be two possibilities, and it is may be that the major economies end up illustrating both cases.

The first possibility is that the economy achieves a soft landing: inflation comes down close to target without any economic downturn relative to trend. If this happens, it suggests increases in interest rates were required, and in that sense team transitory was wrong. [2] The second possibility is if economic activity becomes depressed and inflation undershoots its 2% target. In that case central banks will have overdone their monetary tightening, and team transitory may well have been right.

All the indications are that for the US a soft landing is more likely than not. If this transpires then both the inflation pessimists and team transitory will have been wrong, and the Fed (the US central bank) will have done very well. For both the UK and Eurozone it’s too early to say whether we get a soft landing or not. But in the US at least, at the moment it looks like the experts in the central bank are rather better at managing inflation that many outside pundits. Not a popular conclusion I know, but also perhaps not a surprising one either.

Footnotes

[1] Part of the reason for this is that economic activity is influenced by real interest rates (nominal rates less expected inflation). Only now, with inflation falling, are real rates becoming positive.

[2] This assumes that higher interest rates reduce aggregate demand. As I argued here, the evidence is very strong that they do.