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Is the US economy headed for a soft landing – that is,
for an easing of inflation (the average rate of increase in prices) without
more unemployment?
Former US Treasury Secretary Lawrence Summers doubts
it. "The idea that bringing down inflation has nothing to do with
increasing unemployment runs different from all conventional macroeconomic
assessments.”
Well, let’s see. In the usual model, there is indeed a
tradeoff between unemployment and inflation, given the inflation that
people expect. If inflation is higher than expected, then workers will demand
pay hikes to cover the higher cost of living. Employers will resist with
layoffs.
But if expectations of inflation fall, the whole relationship
between inflation and unemployment changes. Every rate of unemployment can occur
with lower inflation than before. This is
because workers no longer expect such steep increases in the cost of living, so
they don’t demand such high pay hikes. Employers are willing to accommodate their
moderate demands.
The upshot is that in principle, the labor market can
continue to clear but at lower inflation, with no change in
unemployment. In theory, a soft landing is perfectly possible. The Fed "just" needs to lower
expectations of inflation.
But today those expectations are stubbornly high. The
Survey of Consumer Expectations at the New York Fed indicates that people have
been anticipating about 4% inflation for a year, double their expectations in 2020. True, expectations have fallen for three
months, but only slightly.
Another bit of discouraging news is that, unusually,
long-term interest rates have fallen below short-term rates. This usually signals a recession. The idea is
that investors expect a recession to cut spending and thus cut the demand to
hold money. This would lower the price
of borrowing money, which is the interest rate. This may occur because investors
expect the Fed to try to cut expectations of inflation by raising interest
rates now (as indeed it is doing) and lowering them later when unemployment
rises. This would explain the pattern that we observe today: High interest
rates today, expectations that low rates would occur years later.
But the matter is not so clear. Expectations of higher
unemployment haven't changed much for a year. Only about 40% of survey respondents
expect unemployment to rise, and the share is dropping slightly, according to
the New York Fed. This doesn’t suggest that the typical person expects a recession.
As always with the national economy, any
prognostication is a judgment call. I
wouldn't rule out a spike in unemployment in 2024. But neither would I expect
it, as long as the Fed continues to signal that it won't let inflation rise. The
Fed’s sudden if belated boosts in interest rates have been accompanied by a halving
of inflation in a year. I think it’s succeeding.
The key is that the wage, adjusted for inflation, is
rising while job gains are falling. The labor market is heating up, and the
resulting clamor for pay hikes causes employers to think twice about creating
jobs. But this need not cause unemployment to skyrocket. It's a natural
adjustment of the labor market to a rise in labor demand.
The informal forecast of an unemployment spike usually
draws upon our awful experience in the Seventies and early Eighties, when annual
inflation hit 13.5%. The Fed had not been in the habit of controlling the money
supply, and expectations of inflation spiraled out of control. To cope, the new
Fed governor, Paul Volcker, jacked up interest rates to record levels,
engineering a deep recession. This convinced people that the Fed meant business,
and expectations of inflation fell.
Today, thanks partly to Volcker, neither inflation nor
expectations of it are nearly as high as before. It need not be the case that cutting
inflation to 2% now will require a major recession. People have already seen what the Fed is capable
of doing.
I suspect that as long as the Fed is careful, we can
have a soft landing. But I’ve been wrong
before. After all, I’m a journalist. -- Leon
Taylor, Baltimore tayloralmaty@gmail.com
References
Jeff Stein. Larry
Summers was Biden’s biggest inflation critic. Was he wrong? - The Washington
Post
Survey of Consumer
Expectations - FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org)
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