How Painful Will Disinflation Be?

by | July 3, 2023

After lying dormant for decades, inflation has catapulted to the top of the economic agenda since the pandemic.  Dominating the discourse are two related questions: What caused inflation suddenly to surge? And can it be brought to heel without undue economic damage?  

Answering the former can help inform the latter.  Though there’s hardly a rock-solid consensus, a plausible story, supported by different strands of research goes something like this.

The fuse was lit by the pandemic, which induced profound mismatches between supply and demand in multiple product markets.  As consumers shifted from pandemic-shuttered services toward goods whose production and shipment was disrupted, prices for the affected goods leapt, with little offset in services, whose costs did not fall materially.  Commodity prices also jumped, and took an extra leg up after Russia’s invasion of Ukraine. 

Fiscal and monetary stimulus added fuel to the fire.  Not the initial policy response; that was a critical lifeline to keep the economy afloat.  But the unprecedented size, scope, and duration of stimulus in 2021, even after the economy had regained its footing, may have been overdone, as some cautioned at the time. Perhaps it was a case of “fighting the last war.” Widely criticized for doing too little in response to the financial crisis, fiscal policymakers erred on the other side this time.  Federal Reserve officials, similarly chastened by years of struggling to bring inflation up to target, may also have overcompensated, embracing an asymmetric approach that downplayed inflation overshoots, delaying a needed course correction. 

Whatever the cause, policy was too accommodative for too long.  Coupled with a natural rebound as COVID faded, the result has been a level of demand that has stretched the economy’s supply potential, straining resources. Though not the initial catalyst for price pressures, economic overheating has likely helped keep underlying inflation (core, median, trimmed mean, etc.) elevated, edging down only grudgingly even as the original culprits – blocked supply chains, unbalanced demand, soaring commodity prices – have reversed.  If true, getting inflation back down will require the economy to come off the boil, easing resource imbalances.  But can that happen without untoward harm? 

Focus on the labor market: How tight is it?

For evidence of demand stretching available supply, many point to the labor market.  At first blush, this seems odd.  After all, the unemployment rate is no lower than it was prior to the pandemic, when price and wage pressures were nugatory.  Similarly, job growth since February 2020 has run no higher than pre-pandemic estimates of the pace consistent with trend growth in the labor force. And the labor force participation rate of prime-age (25-54) people is back roughly where it was pre-COVID.  What’s different is that job vacancies—positions that firms are unable to fill—surged to unprecedented highs in the aftermath of the pandemic. 

Historically, there has been a fairly stable, inverse relationship between the unemployment rate and the job vacancy rate—the so-called “Beveridge curve.”  Tight labor markets see low unemployment and lots of unfilled jobs; slack labor markets many unemployed and few vacancies.  But this relationship shifted since the pandemic, with vacancies much higher for a given level of unemployment than in the past, suggesting that the labor market has become less efficient at matching people seeking jobs with jobs seeking people. Indeed, at its peak last fall, there were almost two unfilled jobs for every unemployed person – far above pre-pandemic levels.  To many, this is evidence that the labor market is much tighter than before, with firms scrambling to find workers, fueling wage and price pressures. 

On this reckoning, bringing inflation back to target will require reducing the job vacancy/unemployment ratio.  That can happen benignly, without undue economic pain, if vacancies fall absent much change in unemployment—that is, if the Beveridge curve shifts back to pre-pandemic norms.  Some argue that such a soft landing is plausible. Others contend it’s fanciful; that there’s never been a sharp decline in vacancies without a substantial rise in unemployment, of the kind typically associated with a recession, and that we shouldn’t expect one now. 

Who’s right? Much may hinge on why the Beveridge curve shifted in the first place.  It’s hard to be sure, but the pandemic seems a likely culprit. Changes in spending patterns and disruptions to supply chains wrought severe imbalances in labor markets; increased demand for workers with specific skills in certain sectors that may not have matched the available labor pool – especially as pandemic fears and generous stimulus payments led some people to reconsider work-life balance and withdraw from the labor force.

More recently, though, many of these trends have been reversing. Sectoral mismatches seem less acute, and participation is back near pre-pandemic  levels.  Perhaps as a result, the Beveridge curve has been shifting back a bit; job vacancies are down about 15% from their peak over the past year, without any rise in the unemployment rate. And wage growth has moderated, while underlying inflation has edged lower.  Score one for the “immaculate disinflation” camp.  

But victory is far from assured.  Vacancies remain far above pre-pandemic levels, and it would be unprecedented for them to fall that far without a material rise in unemployment.  Even if they did, it might not bring inflation all the way back to target.  History is on the side of the skeptics; threading the soft landing needle is unusual.  But the exception has been the rule since COVID.  And recent signs have been encouraging.  

Here’s to hoping. 

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