The Mysterious, Tearless Disinflation

     The recent fall of inflation did not require a higher level of unemployment. There has been much discussion about who was proved right and who was wrong and whether economics can explain it. Let's try and sort through the noise.

    First, there's always some folks who say Phillips Curves are stupid no matter what happens. An egregious example is discussed here. Such talk is beating a horse that's been dead for almost half a century.

   

     The simple inverse relationship between inflation and the unemployment rate blew up in the Great Inflation of the 1970s. Economists like Emi Nakamura (et. al.) still discuss Phillips Curves that control for inflation expectations and supply (cost) shocks like changes in oil prices.

     Going deeper, if there is no Phillips Curve at all, there is no connection between prices and unemployment, and we are back in a classical world where nominal and real variables are independent. Given the mass of empirical evidence (for example), most economists find this hard to stomach. In his most excellent speech at the AEAs, Ivan Werning said something like, "the Phillips Curve is whatever you use to explain inflation."

     More recently, the debate centered on whether reducing inflation would require a rise in unemployment. Larry Summers said 6% unemployment would be required for the Fed to get inflation down to its 2% target.

     On the graph, this is a standard issue negative demand shock from higher interest rates leading to movement down along the curve.

 

     Of course, such a rise in unemployment did not happen, so what did? Enter the "supply chain disruption" story. The most obvious evidence is the rise and fall in the cost of container shipping. The fall in transportation costs during the recovery shows up as a shift in the Phillips Curve down/left due to a beneficial supply shock.

     Once again, there's a fall in inflation, but this time there's also a fall in the unemployment rate, which did not happen. Digging deeper, vacancies have been falling as well, so there's no evidence of a tighter labor market there, either.

    So how to solve the mystery of the disinflation without tears? Just combine the two stories. Its only a mystery if we insist on thinking about one shock at a time. The combination of a demand shock from the Fed's increase in rates (and the end of COVID era aid) and the easing of the supply chain issues both act to lower inflation but have offsetting effects on unemployment.

     Here's my best effort:

The graph is flawed since it looks like unemployment rises then falls back to u*. A better version would have many PC shifts in between so these increases would be negligible. 

      A paper by Bernanke and Blanchard has even more nuance in that it decomposes the sources of inflation into five categories. Hopefully, they will update their estimates to include the past year, which has most of the disinflation episode.

     On the Titanic "Team Permanent" versus "Team Transitory" debate, we can conclude the former did not win. The complication is that "transitory" means different things to different people. The disinflation did take longer than some thought, and the Fed response looks to be a necessary component, which was a point of contention when inflation was near its peak, and still is for some. So there's still something to argue about, thankfully.

     For now, economic theory did not fail and the Fed gets a pat on the back, while recognizing there are still risks going forward....yadda, yadda, yadda.......