Immaculate Disinflation

(This is another grumpy economist weekly rant script, here)

Today I’m going to talk about immaculate disinflation — lower inflation without recession.

Inflation is stuck above 3% — 3.7% in the September CPI. The hard question for the Fed, and Congress, is how to bring it down. If inflation grows to 4 or 5%, that question will be more pressing.

The usual medicine is higher interest rates. But that might cause a recession. Indeed, that’s the point. The conventional Phillips curve says that lower output and more unemployment are the central causes of lower inflation. Brace yourself for the 1970s and early 1980s.

It doesn’t have to be that way. Immaculate disinflation—without recession or unemployment— is possible.

Even in conventional Phillips curve doctrine, inflation is driven by people’s expectations of future inflation as well as by employment. If businesses expect higher inflation next year, they raise prices now. If people expect higher inflation next year, they are willing to pay higher prices now, and they demand higher wages.

This was the idea behind forward guidance, back when interest rates were zero and the Fed wanted more inflation. The Fed promised to tolerate future inflation. The Fed hoped that expectation would raise inflation right away.

Conversely, If the Fed can get people to believe inflation will be lower next year, then inflation can come down now, immaculately.

But the Fed can’t change expectations with speeches alone. Speeches by public officials telling us to trust in a bright future are the last thing in short supply. And inflation is not just a self-fulfilling prophecy, unhinged from economics.

So how to lower expectations? Standard monetary economics prescribes a durable precommitment to action, not just words. Fed Chair Kevin Warsh is doing a good job of persuading Fed-watchers that he really is an inflation hawk. That helps. But is it enough? Inflation is still rising though perhaps less than it might be otherwise.

Just what will that hawk do if inflation surges? If inflation surges to 1979 levels, will the Fed really repeat 1980, interest rates over 15% despite a brutal recession? If people really believe that, inflation won’t surge to 1979 levels in the first place. But if people doubt that commitment, then hawkish talk will do little. Look up the cute “whip inflation now” buttons from the 1970s. And it could be harder now, when higher interest rates also raise deficits and threaten the too-big-to-fail banks, and unlikely Congressional and Administration support.

The Fed’s “strategy” discussions are attempts to create that commitment. But they tend to be a bit vague with too many outs.

And even so, will higher rates alone work? The 1980s featured important fiscal, tax, spending, and economic reforms too. Without those, it is doubtful that higher interest rates alone would have durably lowered inflation.

The best way to lower inflation expectations is to credibly lower the underlying causes of inflation.

There have been nearly immaculate disinflations in the past. The most classic examples are the ends of hyperinflations following WWI. When the German, Austrian, and Hungarian governments solved the long-running fiscal problems that had caused them to print money, inflation stopped on a dime — with no high interest rates, with looser money, and with no recession. When countries including New Zealand, Israel, Sweden and Canada adopted inflation-targeting in the 1990s, their inflation also dropped suddenly without high interest rates or recession. Those reforms also included tax and spending reforms and microeconomic liberalizations. In Argentina, Javier Milei moved budgets from chronic deficit to surplus — yes, it can be done. Inflation dropped from 25% per month to 2% per month, without a deep recession or high interest rates.

Conversely, higher interest rates without fiscal and economic reform have failed in the past, and led to only greater inflation.

A durable end to persistent inflation comes from fiscal and economic reform along with monetary credibility. Done right, disinflation can be immaculate. Expected inflation collapses, and actual inflation with it, with no recession. Alas, the central bank cannot do it alone.

Update

I wrote this before the Brazil business of the last few blog posts and before the mid-term election. The major point is to remind people that immaculate disinflation is possible. Inflation is not mechanically tied to interest rates as most people believe.

A grand long-term fiscal reform seems pretty unlikely now. Brazil points an uncomfortable direction for US economic future. Steady small primary deficits, unresolved social programs, and desires for greater spending from the most recently elected politicians. Check. Inflation trundling along at 4% or so. Check. The central bank fights inflation with higher and higher interest rates, producing higher and higher interest costs on the debt but not really bringing inflation down. Brazil is one step ahead of us there with 9% real rates of interest, but that may be the US near future. The big difference: the US economy is booming and Brazil’s is stagnating. I hope that spares us Brazil’s conundrum.